Tuesday, January 27, 2009

Three Basic Trade Setups

So much of trading success is a function of pattern recognition, and so many trading patterns boil down to three basic setups:

1) Reversal Trades - The market moves to or just beyond the edges of a trading range (a consolidation area, the value area from the prior day), cannot sustain buying/selling interest, and falls back into that range. The initial target for such a trade will generally be the midpoint of that range (which may also be the pivot level from the previous day or week); a reversal on good volume and very weak/strong NYSE TICK will frequently test the opposite end of that range, as the breakout traders bail out of their positions. I like to be particularly on the lookout for reversal trades in environments in which relative volume is weak, as these tend to be markets that will be pushed around by market makers, not longer time frame participants. (Relative volume parameters can now be found in my Monday AM indicator updates).

2) Breakout Trades - Here we have a situation in which the market is range bound (note the current multi-day trading range in SPX) and surges out of the range, generally on enhanced volume and very high/low NYSE TICK levels. Very often, there will be a catalyst for the breakout (economic news; earnings) and the move will be reflected by other trading instruments and/or asset classes. For instance, if an economic report leads to repricing of other markets (interest rates; currencies), the chances are good that a simultaneous breakout in stock prices is real. The initial targets for breakout moves will be the daily price targets (R1, R2, R3; S1, S2, S3) that I distribute each AM prior to the market open via Twitter (free subscription) and the weekly price targets that appear in my Monday AM indicator reviews.

3) Continuation Trades - Here we have a trend already in place; the idea is to wait for a pull back to enter the trend. A good continuation trade can be thought of as a trade that has already broken above or below its recent pivot level, hit its R1 or S1 level relatively quickly, and now is positioned for possible moves to R2/R3 or S2/S3. We can also think of a continuation trade as a strong daily move that is moving toward a weekly price target as a profitable swing trade. A good continuation trade will show volume expanding in the direction of the trend and contracting on pullbacks. There will also be a trending cumulative NYSE TICK and Market Delta; pullbacks in TICK and Delta will serve as potential entry points. For instance, if we hit R1 and then pull back on light volume and only modestly negative NYSE TICK and Delta, we could reload on the long side for a continuation move to R2.

I hope to illustrate each of these three basic setups in future posts and, as yesterday, alert readers to their appearance via Twitter updates early in trading sessions. The most recent five Twitter posts appear on the blog page under "Twitter Trader"; the complete list of posts appears on my Twitter page. Links for subscription to the TraderFeed blog via RSS can be found below the "About Me" section of the blog page.
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4 comments:

tmangrum said...

just found you from art. in alpha.
have gone back to jan 19 to present and look forward to following along for a while even though i am not a day trader, more of a expiration to expiration or couple of week, mostly xom,tlt, and spy. i won't be able to keep up with you because the only thing that keeps me awake late is a family emergency.

IDkit aka Ana said...

Brett, your classification of 3 basic trade setups rings true for me.

I learn similar patterns from The Nature of Trends(Ray Barros):

1.Reversal - akin to change in trend pattern ie CIT

2. Breakout - as described - normally I don't trade as Risk Reward may not be good.

3. Continuation - trend in place - so I wait for negative development to take a trade for a good RR.

Brett Steenbarger, Ph.D. said...

Hi TMangrum,

Thanks; in that case I hope you sleep well!

Brett

Brett Steenbarger, Ph.D. said...

Hi Ana,

Yes, thanks for mentioning; Nature of Trends is an excellent guide for developing traders.

Brett