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Identifying Profitable Setups

04/17/08 05:34:18 PM PST
by Larry Swing

This term is thrown around, but what's it really mean?

Lots of words are thrown around in trading terminology, but it's not always easy to understand exactly what they mean. At least that's the way it is for me when it comes to the reality of trading. One word I have difficulty with, in particular, is "setup," mainly because it is an all-encompassing word. So some clarification is needed.

A setup means different things to different people. In general, for our purposes, a setup is an area (price or indicator) where a trader would take action; this can be opening a position or closing one. The setup has to meet criteria from price, volume, or any number of indicators being used. Setups can occur at different times of the day or week. For a scalper, setups may appear, one after the other, during a trading day, providing him with many trading opportunities and maybe even make a profit. For a daytrader, these setups may appear from time to time during the trading day. For the swing trader, these setups may appear a few times a week. It all depends on the strategy and indicators the trader uses.

Let's take a look at an example. A setup for a stochastic indicator may be to sell whenever the value of the indicator goes above 80%. Conversely, whenever the value of the stochastic indicator goes below 20%, or it is oversold, it may be a setup to go long. In the 15-minute chart of Apple, Inc. (AAPL), the overbought areas, or short setups, are marked with a red arrow, whereas the oversold areas, or long setups, are identified with a blue arrow (see Figure 1).

FIGURE 1: OVERBOUGHT OR OVERSOLD. Here you see an example of a simple setup. When the stochastic is overbought, it's a setup to open a short position. When the stochastic is in oversold territory, it is a setup to open a long position.

Another type of setup could be to use the overbought and oversold readings of the stochastic with the crossovers of the two stochastic lines. For example, when both the red and blue lines go below 20%, there is no setup. It is only when the red line crosses above the blue one that a setup to take the long trade is indicated (vice versa for short-trade setups).

If you take a look at Figure 2, you can see that there are five long and five short setups. The number of setups would work well for a swing trader, but for others it may be too few or too many.

FIGURE 2: CROSSOVER OF STOCHASTICS. In addition to the stochastic being in overbought or oversold territory, the crossover of the %K and %D lines of the stochastics can also be used to identify setups.

Another type of setup is based on price action. On the 15-minute chart of JDS Uniphase Corp. (JDSU) in Figure 3, you see an example of such a setup. One setup (shaded in pink) is a bottom, from where a long setup is created till a top is formed. After that, a short setup is created.

FIGURE 3: PRICE ACTION SETUP. Once a bottom is formed, it is a setup to open a long position until a top is formed. After you exit that position you can enter a short position when a top is formed.

It is possible to assign one setup to a single pattern or a single movement of the market, either in a downtrend or an uptrend. Basically, a trader can decide that a market top for him is a setup and there will be no others for him until another market top appears. For pattern traders, a triangle breakout is a setup and there will be no others for them until another triangle (or pattern) and prices break out of it. In Figure 4, you see a pattern setup. Here, the pattern is a price channel. When prices touch the bottom or top of a price channel, it could be a setup to enter or exit a position.

FIGURE 4: PRICE PATTERN SETUP. Often, setups are formed based on chart patterns. Here you see an example of a price channel. You can create your setups based on when price touches one of the channel lines.

By identifying one setup from the next, the trader can evaluate how many trades there are in a setup or how many setups there are in a day. This would give an idea of how many trades he should be making per day in order to avoid overtrading. In addition, if he can identify the maximum number of trades he's going to take, this should eliminate taking too many trades from just one setup. By spreading out his trades, he has more opportunities to profit from a setup that will possibly bring him back into the black.

Swing, Larry [2008]. "Daytrading With The NYSE Tick Indicator," Technical Analysis of STOCKS & COMMODITIES, Volume 26: June.

Larry Swing

Larry Swing is the president of the day- and swing trading site, where free daily articles and videos on education, market analysis, and picks from Swing and other well-known traders can be found.


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