Trade opening setups
Trade opening setups
To have a complete trading system you need trade open criteria, entry method, initial stop loss placement, trade management plan, positing sizing method. For a complete trading plan, you need to add list of markets, broker, computer, trading hours, mental preparation, emergency plan, etc.
This article talks about one component of the trading system, i.e. possible setups you can use as a trigger to open a trade and place your entry order (order type will depend on entry method).
Setups you can use to OPEN the trade
- Price Action setup, or a candle pattern, e.g. pinbar, outside bar, engulfing, etc. Search for “price action” and “candle patterns” to read more. Here is a good list of candlesticks patterns or this classic book. For price action, here is a good primer. Price action trading includes trend analysis and bars patterns such as pinbar, inside bar, bullish outside bar, etc. There is no need for me to repeat a good existing material incl. baby pips school. Fractal is also a candle pattern, a 4 or 5 bars pattern that happens at each swing high or low.
- Indicators behavior, e.g. RSI below 30 and turned up, or CCI above 240, etc, i.e. any setup driven by indicators. It can be based on indicator value, e.g. above 70, or indicator behavior, e.g. turned up, diverge from price, indicator trend line break, etc. See Dr Alex Elder book or ask google for indicators description. If you choose to use indicators as your opening setup, make sure you really understand how they are calculated (what in fact they show). Note that indicators do not have a predictive power. They merely show if the price went up or down, or the speed of move has increased or decreased. Or, like ADX, they show a trend strength, regardless of direction. Or, like ATR, they show volatility. They can be very useful, but please understand they are merely a different way to present the price action. Another important concept related to indicators is divergences. You can read on them and learn to identify them on charts. Many key reversals are accompanied by a divergence. Unfortunately not all divergences produce a reversal.
- Chart Patterns, e.g. head & shoulders, flag, triangle, trendlines, 1-2-3 pattern, etc. Technical analysis classic. Read about them, as anything you may want to use, please backtest it: see tens if not hundreds of occurrences of your setup on chart, train yourself to spot them, see if you think you can be profitable trading the pattern. Entry is usually on the break of the pattern (with the stop as an order type and “on the break” as en entry method).
- News event, such as central bank rate change, payrolls data, inflation data, or even a political event. Great source for news events is forex factory calendar. News websites such as Reuters, bloomberg, marketwatch or others can be a source, too. Brokers often offer access to Reuters newsfeed. Remember though, that, as a retail trader you have no edge on news timely access. In my opinion it is very difficult to become profitable trading news. I certainly am unable to do so. Most people I talked with advise against trading the news. Daytrading during news release means higher spreads, higher volatility. A seemingly effective strategy of trading a breakout with stop orders, will often fail as the markets go up and down before it “decides” where to do. However, I see two interesting ways of using the news. First, is to see how the market reacted to news to gauge a sentiment. If it is not going down in spite of bad news, it may indicate it “wants” to go up. Secondly, you can combine fundamental and technical analysis and use news events to consider longer term setups, e.g. a trade that will last a few days or even weeks, based on a central bank (e.g. go long the currency that hikes the interest rate). This can be more effective if combined with a technical analysis based entry method, e.g. use some candle pattern to time the entry and place the stop, based on a formation.
- Support and Resistance, i.e. technical analysis classic, can also be used as an open criteria, or a filter, too. For example, short at a resistance, buy at a support. Could be “blindly” with limit orders, or waiting for a reaction at a level, e.g. if the price approaches resistance and shows a bearish candle, then go short. Otherwise, do nothing. Or, want for a level to be broken, and enter in this direction. Or trade false breaks of the key level, i.e. see a price break the key resistance (triggering lots of buy stop orders for traders who are short and are closing their trades and traders who are entering on the break) and reverse. Join the down move. This idea is often referred to as “false break trading” or “fade the breakout” or “turtle soup system”. Search for this and feel tree to test this idea (as anything else before you trade it live).
- Supply and demand, i.e. trading the supply and demand levels as described in my system post: these are places where there was a supply vs. demand imbalance, which we see on chart by the price moving away fast and far from the level, after a brief consolidation. This is what I use for my trading, as I found it work for me, after trying many other things.
- Elliott Wave and harmonic patterns, geometry. One of the schools of technical analysis is waves analysis, wave 1,2,3,5 in the trend and A,B,C in correction, with waves 1,3,5, being impulse and 2 and 4 correction waves. Many people claim to be profitable trading this. Among many sources I found on this concept, the book by Robert Miner “Dynamic Trading” was very good and explained it clearly, offering a complete trading method (vs. just a way to count waves). Geometry is an idea to look for relationships between corrections or trend lengths in time and price, often using fibo numbers. Very often they strikingly accurately work as a price turning points. However, you never know which level will work. There are ways, in these concepts to predict this by looking for areas where number of retracements or expansions are aligned, e.g. fibo retracement of the recent trend at 68% and fibo expansion of AB wave length from a potential B point is 100%. Or, more simply, 100% of the recent correction length. Combine it with a key S/R level and trend direction and it may be a good method.
- Volume. Volume itself, you can use in many, many ways. There are also indicators based on volume such as OBV and others. There is a school of analysis called “Volume Spread analysis”, if you google on it, that claims to really reveal how the markets work, accumulation and distribution phases, how the smart money makes money by manipulating the market, price and news. Very interesting and might be the idea for you. As I repeatedly say, everyone needs to find theirs. The method right for them, which you learn from Market Wizards books. Another point on volume in forex… we do not know the real volume. We use tick volume as an approximation. To what extent it works is debatable.
- Other markets. Your setup to trade may be driven or triggered by a price action on a different market. For example go long S&P if VIX (CBOE volatility index) is above 20 and turned down on daily timeframe) as this may indicate a correction end. Close a long S&P position if VIX reading is very low, e.g. 12. Another idea: use fundamental or technical analysis or USD index, to find the strongest and weakest currency pair and match them to choose which market to trade and trigger a trade, e.g. if you believe EUR is strong and JPY weak you can trade long EURJPY (which is essentially a long EUR short JPY trade). Another idea is pairs trading: look for usually correlated pairs and if their charts diverge go long the one that is “too low” and short the one that is “too high”, in a prediction that the charts will soon converge, while a directional move is neutral to you. This is a more advanced strategy and makes it more difficult to manage the risk (requires a mental stop). Carry trade is a concept you may read on. In short, go long the pair with high interest rate, short the one with low rate (texbook example is long AUDJPY) and make money (swap points, rollover) for keeping the trade. It is not a holy grail because you can loose money as a result of the price move.
- Intuition. Read the “Trading from Your Gut” by Curtis Faith to learn about whole-brain trading (not just left brain which uses reasoning). The book is a must read for everyone, trading based on your gut feel is for more advanced trades who, thanks to hundreds of hours screentime have trained their intuitive brain to see patterns subconsciously, after they have seen thousands of times a pattern did or did not work. But again, in my opinion, before we very deeply learn a trading system, we should not trade purely beased on gut feel. But do train the intuition and listen to it over time.
- Always in the market. Here I refer to trading systems which are always in the market, either long or short. They may or may not also have a opening (or rather position reversal) setup. For example a trading system based on moving averages (e.g. long on cross above EMA 50, short on cross below) [unfortunately it seems, based on my testing, mechanical systems like this are not consistently profitable, they are sometimes profitable: in trending markets]. Also a “buy-and-hold” which is a “system” people use for stocks in system that is “always in the market”
- Random. Yes, however ridiculous it sounds, there can be systems with a random entry trigger and direction. Theoretically, if a trading closing method and position sizing method gives a good enough edge, then a system with a random entry could make money. Tharp says in his book that he backtested random entry system with good exits and it produced profits. I tried in Amibroker, tested hundreds of iterations of random entry systems and some of them were indeed profitable, but only if I eliminated transaction costs 😉 But it is not impossible that a system that does not has an entry edge, can be overall profitable. Just like systems based on concepts like astrology and things like this.
- Anything else. This list is not complete. It is to list ides, while there can be many more reasons to open a trade. Again, everyone needs to find what works for them.
- Any combination of the above. To increase number of possibilities even further, any combination of the above may also work, incl. adding some conditions as filters and/or looking at same/other conditions also at a higher timeframe! Combinations are powerful. If you have a higher timeframe trend and a key level and a price action all aligned, this is likely a high quality trade.
- Lastly, I’d like to mention a few things that are NOT good reasons to open a trade. Do not open a trade for the following reasons: a revenge trade, i.e. “I have just lost, so now I must open a trade to make it back, and maybe even double up”. Do not reverse just because you were stopped out. It may be OK if this is a codified and previously tested part of the trading system, but reversing a position just because the stop was hit is usually a bad thing. Do not trade because you really wanted to end this day/week/month in profit. This leads to over trading. Do not trade if your setup is not on the chart. Do not trade based on ideas from other people. Do not trade if a minimal lot size and stop distance make the potential loss too high for you. Do not trade if you feel bad, physically or mentally, e.g. if you are stressed or distracted, as this deceases our brain’s effectiveness.
The above are setups, or triggers, or, in other words, a thing you need to see on the chart before you open a trade. And, if you follow your system, you trade only if the opening criteria are met. If there is no trade setup on the chart, you do not trade. This is often the hardest part 😉