“Luck is what happens when preparation meets opportunity.” – Seneca (Roman philosopher)

 

“I like to go for cinches. I like to shoot fish in a barrel. But I like to do it after the water has run out.” – Warren Buffett

Set-ups are a key source of edges.

They help you stack the probabilities in your favour.

The better your set-up, the greater the chance of having a winning trade. The more winning trades you have, the easier it will be to achieve your objectives through your position-sizing model.

There are numerous set-ups – probably almost as many as there are traders – and it is a matter of finding damn good set-ups that suit your personality. If you try and copy someone else, you will find it difficult to ever feel confident enough to trade at size.

But what you can do is take damn-good set-ups and make them your own. In this lesson we go through several set-ups that you can adapt for your trading plan. When you find one you like, get to know it intimately. For each of your set-ups, you want to learn:

  • Its probability of success
  • What the price action looks like when it fails
  • How far the moves go when it succeeds

When you truly understand your set-up, you can make it your own, and when you do that, even an average set-up can become damn good.

Set-ups are not entries

Once you uncover your set-up, you then go into stalking mode.

You can place a trade when you see a set-up, and some set-ups require you to, but often you will be better waiting for the opportune moment to enter.

It’s all about optimizing the risk to reward. If you are patient, you will generally be able to find an entry level that lets you earn 2 or 3 times more from the trade. This may mean that sometimes you miss out, as the opportunity does not materialize, but as a “rules-based discretionary trader” we are not looking to take every trade – only the ones that really stack-up.

A risk/reward filter for your trades

The concept behind a risk/reward filter is that don’t place a trade unless the potential reward is greater than the risk by a certain amount. For example, your might not take a trade unless the potential is to make at least three times the profit compared to the risk.

When you assess a set-up you want to determine if the risk/reward is right for you. Generally it’s best practice to look for a risk/reward of at least 1:3, though for short-term trades its acceptable to have a lower risk/reward ratio.

You will learn how to improve the risk/reward on your set-ups in the next lesson on stalking an entry.

A word of caution

“What really matters is the long-run distribution of outcomes from your trading techniques, systems, and procedures. But, psychologically, what seems of paramount importance is whether the positions that you have right now are going to work. Current positions that you have beyond any statistical justification. It’s quite tempting to bend your rules to make your current trades work, assuming that the favorability of your long-term statistics will take care of future profitability. Two of the cardinal sins of trading – giving too much rope and taking profits prematurely – are both attempts to make current positions more likely to succeed, to the severe detriment of long-term performance.” – William Eckhardt, Market Wizard

Set-ups can be very entrancing. It’s easy to get sucked down the rabbit hole and spend far too much time on this aspect of your trading plan.

As a general rule, you want to spend 10-15% of your system development process time on set-ups.

You also want to be very clear on your objectives. If you are looking for long-term trades, then your set-up should be congruent and vice versa with short term trades. Too many traders make the mistake of using set-ups that don’t suit their objectives, and it results in them cutting their losses short, or getting stopped out far too often.

For example, if you are looking for long-term moves of several hundred pips, your set-up should be developed on a higher timeframe, such as weekly or daily. It’s no good looking for a set-up on an hourly chart if you’re trading for the long-term (though you can go down to the hourly chart to stalk an entry).

Combined set-ups

“Fundamentalists who say they are not going to pay any attention to the charts are like a doctor who says he’s not going to take a patient’s temperature” – Bruce Kovner, Market Wizard

While you can trade effectively using a set-up on its own, often your probability of success on the trade will improve if you can combine more than one factor.

For example, if you have a fundamental view, and then you get an excellent technical set-up that supports your view, then your trade could be much better than if you had only one of these factors in your favour.

Some damn good set-ups

“Sometimes the opportunities are so obvious that you almost can’t lose when they come around; the only problem is that they don’t come around that often. The key is not to lose money in the times in between.” – Stuart Walton, Market Wizard

If you pick up any book on Forex trading, it is likely packed full to the brim with set-ups. In general you will find a lot of them work, and will give you an edge. What the books probably don’t cover are the position sizing and trade management techniques you need to turn that edge into profits.

It would be impractical for me to cover anywhere near the number of set-ups that you will come across through-out your trading career, and if you learn or have learnt ones from elsewhere that fit you, then that is good. Take what you have, and work on the other elements of your trading plan.

Set-ups generally fall within two categories:

  • Technical
  • Fundamental

Let’s look at few of these now.

Technical analysis set-ups

“I haven’t met a rich technician” – Jim Rogers, Market Wizard

 

“I always laugh at people who say “I’ve never met a rich technician” I love that it’s such an arrogant, nonsensical response. I used fundamentals for 9 years and got rich as a technician” – Marty Schwartz, Market Wizard

Technical set-ups are based on chart analysis. Charts can be a window into the soul of your trade, and fortunes have been made by their application.

But charts can also be very easily misunderstood by the newbie who tends to make things much more complex than they need to be. The trick with chart analysis is to keep things simple, look for low risk/high reward entries, and then focus on managing the trade after you get into it (a topic of a future lesson).

Technical indicators

“The 10 day exponential moving average (EMA) is my favourite indicator to determine the major trend. I call this “red light, green light” because it is imperative in trading to remain on the correct side of a moving average to give yourself the best probability of success. When you are trading above the 10 day, you have the green light, the market is in positive mode and you should be thinking buy. Conversely, trading below the average is a red light. The market is in a negative mode and you should be thinking sell.” – Marty Schwartz, Market Wizard

One of the most common ways to use charts is to use technical indicators such as Moving Averages, Bollinger Bands or Stochastic Oscillators. While these indicators are too numerous to go into in this lesson, let’s look at some best practice around how you use an indicator in system development.

  1. The indicator needs to have a purpose. You should not add an indicator to a chart unless it helps you do something specific. For example, you might apply the ADX to confirm a trend, or use a Parabolic SAR as a trailing stop.
  2. The indicator should not cause confusion. Many traders apply too many indicators to their charts and they conflict with each other. While it can be good to have 2 indicators confirm a set-up, adding 3 can just cause confusion and indecision.
  3. Keep in mind that Indicators are fictional. Ultimately, indicators are just lines on a chart. They are not real. Just because your indicator gives you a buy signal does not mean that anything has actually happened. The markets are driven by supply and demand, and will move based on market orders. While indicators can be immensely useful, it pays to keep this very much in mind and remember to practice risk management.
  4. It pays to get to know your indicator. Rather than chopping and changing indicators, it can be good to get to know you indicator intimately. Learn to use it on different settings, timeframes, and currency pairs

Support and resistance (key levels)

Support and resistance levels indicate previous price levels where buyers or sellers have stepped into the market and price has changed direction. If a level has held in the past, it can be an indication a level will hold again in the future.

Support and resistance can make good set-ups, as the price can reverse off these levels.

The higher the timeframe, the more powerful the support and resistance level. Support and resistance that shows up on weekly charts can signal important turning points.

Daily and weekly pivot points

Some traders use daily and weekly pivots to great effect.

The concept behind pivot points is that more often than not, price will stay inside the reversal zone. In a sideways market type, the price moves from one pivot point to another. There’s a whole scholarly discussion on pivot points, and how price action moves between them. For example, if the central pivot holds, then it will go to the “reversal zone”.

Pivot points can be used as setups in both trending and sideways market types. They also work well when combined with support and resistance setups above.

Chart patterns

Classic technical analysis patterns are used by chartists to time the markets. These patterns help a trader recognise the supply and demand factors that drive the markets, and are often reflections of market psychology.  The patterns listed below are some on more common ones:

  • Symmetrical Triangles.
  • Ascending Triangles.
  • Descending Broadening Wedge.
  • Ascending Wedge.
  • Head and Shoulders.
  • Inverse Head and Shoulders.

There is plenty of literature for you to dive deep into chart patterns if want to learn more.

Big money can be made by the contrarian picking tops and bottoms

“I consider myself a premier market opportunist. That means I develop an idea on the market and pursue it from a very low-risk stand-point until I have repeatedly been proven wrong, or until I change my viewpoint” – Paul Tudor Jones, Market Wizard

Picking tops and bottoms is not for the faint hearted.

You need to be prepared to take the opposite view to the crowd, and fearlessly buy when others are selling. You also need to be flexible enough to admit when you are incorrect. The trading landscape is littered with ego driven traders who refused to believe that they wrong. The market cares little for your views…

But if you do manage to get in on a top or bottom then you can stand to make very large returns.

To pick the turning points you can look for double tops and bottoms or head and should patterns. If you see one of these it could be a sign the market is set to change direction and this makes quite a good set-up.

If you are looking to pick tops and bottoms don’t expect to get it right the first time. It might take you several goes before the direction goes for you, so keep your risk management tight.

Consolidations

The Forex market expands and contracts from periods of volatility to quiet periods. These periods of quiet can make excellent set-ups, as when the market expands, the moves can be rapid and the risk vs reward excellent.

These periods of consolidation happen across numerous timeframes, from weekly right down to intraday.

Correlations

Some experienced traders look at not only the currency pair they are trading, but also check to see how the currency they are planning to trade is performing against other currencies.

For example: if there is a lot of demand for the AUD against the JPY, this could have positive implications for the AUD against the USD.

Time of day

Due to the 24 hour nature of the Forex markets, money flows into currency pairs at different times depending on market opening hours in the US, UK and Japan.

During times of money flow, you might expect to experience more breakouts, while during quiet times you might expect the market to range trade more. This does not always hold true, though, as if a trend gets going during quiet illiquid times then it can be a wild ride with no volume to hold it back.

Time of day is a very important set-up that traders often neglect. If you can place trades at optimal times that suit your strategy, then it can improve your edge.

Forex Money Flow  (GMT Time)

  • Tokyo 12.00am Tokyo money flow
  • 6:30am-7:15am Pre-London
  • 8:00am London Open
  • 12:20pm-12:40pm Pre-New York (Early New York Money & Professional Traders)
  • 1:00pm-1:30pm New York Open (Banks, pits, etc)
  • 1:30pm Money flow Stock Market Open
  • 1:45pm-2:15am Daily Spot-Trade
  • 5:00pm- Money Exit

High probability trades can be found when there is strong support or resistance at market opens.

Fundamental set-ups

“I develop a macro view about something, but then there are 20 different ways I can play it. The key question is: What gives me the best risk/reward?” – Michael Platt, Market Wizard

Fundamental set-ups are based on supply and demand factors. Generally, the more a currency is in demand the more it will strengthen.

Fundamental analysis of currencies is, like technical analysis, an immense topic. It is also tricky, as the market often “prices in” the fundamentals, so when you get news that you think is positive for the currency, it may actually go down.

This is to say that certain assumptions are sometimes already in play. For example: if the market expects the New Zealand central bank interest rate to rise by .5%, and it only rises by .25%, the price of NZD may actually fall, even those the interest rate rose. More on this below.

Interest rates and Central Bank policy

“A counter to anticipated response to market news may be more meaningful than the news item itself. Platt recalls a trade in which there was a continuing stream of adverse news. He repeatedly expected to lose money after each news item, and yet the market did not move against him. Platt read the inability of the market to respond to the news as confirmation of his trade idea, and he quadrupled his position, turning it into one of his biggest winners ever” – Jack Schwager, author of Market Wizards, discussing lessons from Michael Platt

You can think of currencies a little like bank deposit and loans. For example if you buy the AUD, then it is like have a deposit in an account in AUD from which you earn interest. If you are selling it against the USD, it would be like having a loan in USD in which you pay interest. If you earn more interest than you pay, then you have a positive carry. I.e. you will earn money just for holding your position.

In addition, inflation and deflation can have a significant impact on the long-term performance of currency pairs. If more currency is being created due to inflation, then supply of the currency pair increases. If currency is being destructed due to deflation, then it decreases supply of a currency pair.

Finally central banks around the globe have begun programs of quantitative easing, i.e. money printing, which impact the supply and demand of currencies.

Because of this, the actions of central banks around the globe are heavily scrutinized, and their policies can be significant drivers of movement in currency pairs. But it is not all as simple as it may seem. Even if a central bank is printing money, the currency may strengthen due to debt deflation or money supply.

As a Forex trader, interest rate and other central bank policies can be very good set-ups for trades. A good recent example is the JPY in 2013-14 where the Bank of Japan was aggressively easing monetary policy, leading to some very good short JPY trading opportunities.

Economic news

“Fundamentals that you read about are typically useless, as the market has already discounted the price. I call them funny-mentals. However, if you catch on early, before others believe, then you might have valuable surprise-a-mentals.” -Ed Seykota, Market Wizard

Economic news can be a significant factor. Often traders look to interpret what it means the central bank will do, rather than the significance of the underlying event. In other words, interventionism has added another layer to the puzzle.

None the less, economic news releases can be very good trading set-ups. If the news is different to what the market expects, it can lead to rapid movements in currency pairs. News will often serve to reverse or continue a trend, so it can pay to know what upcoming news events are of significance, even if you are not trading the news itself.

There are plenty of ways to use news as a set-up. Some traders will:

  • Look to predict the news event’s outcome, and place a trade beforehand.
  • Wait for the news event, and frantically enter the trade based on the announcement.
  • Wait for the reaction to the news event, and place the trade 5 minutes after.

All are valid strategies; you just need to choose the one that appeals to you and gives you an edge.

Your turn

“I think investment psychology is by far the more important element, followed by risk control, with the least important consideration being the question of where you buy and sell.” – Tom Basso, Market Wizard

 

“[It’s] not some magical source that is the key to the markets, as most people believe. The metaphor of the “Holy Grail” ………….is all about finding yourself.” – Van Tharp, Market Wizard

Now it’s your turn.

Select some damn good set-ups for your trading system. You want to make sure they:

  • Fit your psychology
  • Fit the other elements of your system
  • Give you an edge

Make sure you don’t just settle for the easy option. Technical analysis can be seductive because it’s simple to get started and intriguing, but you will find that some of the other set-ups will yield more fruit.

And remember that set-ups are only one of the sources of your edges. Others, such as position-sizing and exits, are of significance too.

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Until next week,

Sam

Sam Transparent Circle

Course work

  • Choose the damn good set-ups you will use for your trading system in the course work.