How to Use Setup Trading

Setup trading is a form of swing trading that’s very popular today. A setup is a particular configuration of trading price bars, usually with one or two other confirming conditions like a pattern or an indicator, that delivers an expected outcome in a high proportion of trades. Setups usually have catchy names (such as pinball and coiled spring).

Each setup identifies a specific market condition that can be explained in terms of market psychology. Setup analysis is promiscuous, borrowing from bar reading, pattern identification, and indicators. One benefit of setup trading is that you can be out of the market until you spot a setup situation. You take no risk when you’re out of the market.

Starting off early

A setup identifies the conditions that precede and accompany a price move, giving you a head start in entering a trade. When you correctly identify the setup, the price goes in your direction immediately. And when a strong move begins, the first few days can account for 25 percent or more of the total move. That’s the thrust or impulse aspect of new moves.

Efficient entries are the hallmark of setup swing trading, but risk management is the key feature of setup swing trading and thus appropriate for beginners. You must

  • Never give up profits by sitting out a retracement.

  • Absolutely, positively use stops and keep them updated.

Exiting the setup game

For the most part, you don’t scale into and out of setup trades. You determine the amount to trade only once. The next part of the trade — the exit — borrows a page from the professional playbook: Ruthless stops. The playbook offers the following tips:

  • If the setup is a dud — it fails or you have not identified it right — you need a stop at a level of loss that you can tolerate. All good traders use stops, but if you have a problem obeying your stops, setup trading might be for you. You go broke fast without stops, and so you have to force yourself to use them.

  • If the setup succeeds, you keep moving your stop upward to secure each new level of gain when it occurs. Generally, you hold until the price moves against you by some specified amount. Sometimes setups are so short lived that an initial stop is all you need and you’re not in the trade long enough to use a trailing stop. Setup trading can be hit and run.

Drawbacks to using setups

Drawbacks to this technique include

  • A setup that you like may not appear every day or even every month. With a small universe of securities, you’d have to memorize a dozen setups if you want to be in the market most or all of the time. If you like only one or two setups, you have to monitor a large universe of securities.

  • If you focus on setups to the exclusion of all the other concepts in technical analysis, you’re at a loss for what to do when setups don’t appear.

  • To find your favorite setups, you have to scan a list of securities, and the best setups may appear in securities that you wouldn’t touch with a bargepole on a fundamental or value basis.

  • Setups require intense concentration and often the ability to trade actively during market hours. If you have a day job, this task can be impossible to do. And remember, active stop management is critical to success, meaning that you really should be out of the market altogether when you go on a vacation or business trip. War stories about hair-raising losses usually involve not having placed a stop and learning about some market-moving event only after arriving in an exotic location.

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