I was just reading the thread
here and it got me thinking about several topics. I decided to write down some thoughts about how I think about Setups. I would appreciate any and (almost) all comments on the ideas expressed herein, perhaps this will stimulate a productive discussion.
When I think about "setups" I like to think about the following question "What do markets do?". For myself, I first break markets down into two broad categories or "States":
- Market trading within an area of "value" or within a "
trading range" or sideways channel. Generally the participants have accepted the current
range of prices and are happy to do business in that range. "Acceptance"
- Market is moving out of "value" or trending. Some or most of the participants have changed their opinion about what price the underlying instrument is worth and the market is trying to figure out where the new balance of perceptions of value is. "Exploration"
Given these two broad market states, I then ask the question "What are the different things markets do when they're in or changing between these two states?". Again I come up with a small list:
1. moving between the extremes of the generally accepted range of value (i.e., a trading range or channel).
2. changing direction at one extreme of a trading range or channel.
3. beginning a trend (breaking out is a subset of "beginning a trend").
4. pulling back while still trending.
5.
reversing a trend.
(Note: I make a distinction between 2 and 5 because I view them as very different events (with different causes and outcomes) even though both involve a change of direction.)
My opinion is that most “setups” can be classified into one of these 5 behaviors. We are all aware that particular setups work better in some contexts than others. I (and many others) would argue that
Context is the most important thing for a discretionary trader. We must first form an opinion about which of the two broad states the market is currently in and then which of the 5 behaviors we are about to place a bet based on. As a simple example, you wouldn’t want to use some kind of a with-trend
pullback entry method if your opinion is that the market is in a trading range (i.e., not exploring to find a new area of value).
An additional element required when forming opinions about the above is a consideration of timeframe. It is familiar to all that a trend on one timeframe may be part of a trading range on another timeframe and vice versa. In fact, I would say it is impossible to speak about market state or behavior unless one qualifies the timeframe one is talking about. To extend the pullback example above, if your opinion is that we are in a trading range on the daily chart (say for the last three weeks), then if you want to use a pullback entry method, you need to be looking at a smaller timeframe – one in which you can define state and behavior appropriately (i.e., as a trend).
A word of caution: It may seem that I’m suggesting you must simply look to lower timeframes until you find the state and behavior you are looking for. However, there’s a problem with that. The problem is that, as a general rule, the lower the timeframe you go to the more difficult trading becomes. I think there are two main reasons for this (others may suggest more): The first is that it is easier to manipulate markets on shorter timeframes because the expense involved in doing so is less (e.g., it is easier to push a market below a level of support to blow the stops of short-term traders than it is to do the same for long-term traders because long-term traders will generally have wider stops). The second is that on longer timeframes you will have more time to evaluate Context and make decisions.
My point here is that Context is the most important thing for a discretionary trader to determine. Context (State and Behavior) must be determined prior to looking for a setup and the setup has to be chosen based on the State and Behavior you think are happening. State and Behavior are necessarily linked to a timeframe – you want to define State and Behavior using timeframes that are appropriate for the timeframe you are looking for setups on. (Hopefully it is obvious that choosing your trading timeframe has direct consequences for your trade size, stops, and targets).
