How to Trade Using the Vertical Horizontal Filter (VHF)

Introduction to the Vertical Horizontal Filter (VHF)

The Vertical Horizontal Filter (VHF) is a technical analysis indicator developed by Adam White to measure the trend strength of a security. Unlike trend-following indicators such as moving averages or the MACD, the VHF does not indicate the direction of the trend but rather the extent to which a security is trending or ranging.

Traders use the VHF to determine whether they should employ trend-following strategies or range-bound trading strategies. A high VHF value signals a strong trend, while a low VHF value suggests a sideways or consolidating market.

Formula for the Vertical Horizontal Filter

The formula for calculating the VHF is as follows:

Where:

• HighestHigh = Highest price over the selected period
• LowestLow = Lowest price over the selected period
• Close_t = Closing price at time t
• Close_{t-1} = Closing price of the previous period
• n = Number of periods used in calculation (commonly 14, 28, or 50)

The numerator represents the difference between the highest and lowest prices over the given period, while the denominator sums up the absolute daily price changes. A higher ratio indicates a stronger trend, while a lower ratio suggests consolidation.

Understanding VHF Readings

• High VHF Value: A high value suggests a trending market, which can be either bullish or bearish. Trend-following strategies such as moving averages and breakout trading work best in this scenario.
• Low VHF Value: A low value indicates a ranging or consolidating market where oscillators like RSI, Bollinger Bands, and support/resistance trading strategies are more effective.
• Rising VHF: Indicates a developing trend.
• Declining VHF: Suggests that the trend is weakening and might transition into consolidation.

Trading Strategies Using Vertical Horizontal Filter

1. Trend-Following Strategy with Moving Averages

Objective: Use VHF to confirm trending conditions and apply moving average crossovers.

Steps:

1. Calculate the VHF for a 28-period or 50-period timeframe.
2. Identify periods where VHF is rising and above a threshold (e.g., 0.5 or higher).
3. Apply a trend-following moving average system (e.g., 50-day and 200-day moving average crossover).
4. Enter long trades when the 50-day MA crosses above the 200-day MA (Golden Cross).
5. Enter short trades when the 50-day MA crosses below the 200-day MA (Death Cross).
6. Exit when VHF starts declining or when a reversal signal appears.

Example:

• Stock XYZ has a rising VHF of 0.6.
• The 50-day MA crosses above the 200-day MA.
• A buy trade is initiated and held as long as the VHF remains high.
• When VHF starts declining, traders can either tighten their stop losses or exit the trade.

2. Range-Bound Trading Strategy with Bollinger Bands

Objective: Use VHF to confirm a consolidating market and trade within the range using Bollinger Bands.

Steps:

1. Calculate VHF for a 28-period timeframe.
2. Identify periods where VHF is low (e.g., below 0.2), indicating a sideways market.
3. Apply Bollinger Bands (20-period, 2 standard deviations) to identify overbought and oversold levels.
4. Enter long trades when price touches the lower Bollinger Band and RSI confirms oversold conditions.
5. Enter short trades when price touches the upper Bollinger Band and RSI confirms overbought conditions.
6. Exit trades when price moves back to the middle band or VHF begins to rise.

Example:

• Stock ABC has a VHF of 0.15, indicating a sideways market.
• The price touches the lower Bollinger Band, and RSI is below 30 (oversold).
• A buy trade is entered, targeting the middle Bollinger Band.
• A sell trade is executed when the price reaches the upper Bollinger Band and RSI is above 70 (overbought).

3. Breakout Strategy with VHF Confirmation

Objective: Identify breakout opportunities by waiting for a low VHF to transition into a rising trend.

Steps:

1. Identify securities with a low VHF (below 0.2), indicating a range-bound phase.
2. Draw horizontal resistance and support levels.
3. Wait for a breakout above resistance or below support with an increase in VHF.
4. Enter a long trade if the price breaks above resistance with a rising VHF.
5. Enter a short trade if the price breaks below support with a rising VHF.
6. Use stop losses below support for long trades and above resistance for short trades.
7. Take profit when VHF reaches an extreme level (e.g., above 0.7) and shows signs of flattening.

Example:

• Stock LMN has a VHF of 0.1 and trades within a range of $50-$55.
• A breakout above $55 occurs with VHF rising above 0.3.
• A long trade is entered with a stop loss at $54.
• Profit is taken when VHF reaches 0.7 and begins to decline.

4. VHF and ADX Combination for Trend Strength Confirmation

Objective: Use both the VHF and the Average Directional Index (ADX) to confirm the strength of a trend before entering trades.

Steps:

1. Calculate both VHF and ADX (14-period or 28-period ADX).
2. Look for periods where both VHF and ADX are above 25, confirming a strong trend.
3. Apply trend-following indicators such as Parabolic SAR or MACD for trade entries.
4. Exit trades when either VHF or ADX begins to decline significantly.

Example:

• Stock PQR has a VHF of 0.6 and an ADX of 30.
• A buy trade is entered using a MACD crossover confirmation.
• Profit is taken when ADX starts declining below 25 and VHF flattens.

Conclusion

The Vertical Horizontal Filter (VHF) is a powerful tool for distinguishing between trending and range-bound markets. By integrating VHF into trading strategies, traders can optimize their approach by selecting trend-following strategies during high VHF periods and range-based strategies during low VHF periods. Whether using moving averages, Bollinger Bands, breakouts, or ADX confirmations, VHF helps traders improve decision-making and increase profitability.