1. A setup refers to conditions that must be met before any other action takes place. They are essential for most entry and exit steps in any system. Before we pay money and enter a position, certain criteria must be met. That criteria is our setup. We spend countless hours looking for the right conditions that will entice us to take the risk, to lay the money down, in hopes of making a profit.
2. The most important criteria in swing trading is to have enough volatility, enough change taking place, to let you make a profit that is two to three times your initial risk.
3. Swing traders take advantage of failed-test setups, where the market tests a new extreme and then falls back. The figure below shows several swing entry opportunities. Notice, in each case (the candles within the white circles) the price extends upwards but fails to continue its rise and falls back. That is a failed-test. What is needed in this pattern is some sign of reversal, which is shown in each case.
4. An important point to reemphasize is that setups are not usually criteria for entering the market. They are conditions that must occur before the entry takes place. Other confirming signals must be met.
5. The following trending chart (Fig. 1) illustrates five failed-tests that could be considered as setups. Notice the dark candles in each circle showing decreased prices, leading to the uptick the swing trader hopes to capitalize on.
6. It is easy enough to see the value in a failed-test as a potential entry point, but what is the confirming signal required? The first four failed-tests would lead to a potential profit. However, the last one on the right just didn’t turn up. What was the difference there? This is where some confirmation is necessary.
Fig. 1 Failed-test setups
7. We’ve mentioned technical indicators in previous posts and the following graphic (Fig. 2) answers some of the questions posed in Fig. 1. At the top of the figure we’ve circled those indicators shown in the top segment, Moving Averages and Bollinger Bands. The two MAs are used to observe changes in trend patterns when the short and long MAs cross. This occurs or is about to occur on the far right of the chart. Notice the other position the MAs crossed, at about the start of the long up-trend. MAs are lagging indicators.
8. The other indicator circled and present on the chart is the Bollinger Bands. This indicator signals the channel in which the prices vary, flagging the volatility of price movement, widening when the price bars are long, narrowing in periods of congestion. Notice how during the uptrend the bands were wider, beginning to narrow as price volatility decreases. This is one flag that the last circled failed-test on the previous chart is less likely to provide a profit going forward.
9. The bottom window, below the volume, has two new indicators, the Stochastics and the MACD. We will cover both in detail in following Guidelines, but consider first the Stochastics: It is the red and yellow lines crossing down through the very light line which represents 80 on the 0 to 100 scale. When this occurs it is a sign to get ready to sell. That is an appropriate signal considering the failed-test shown in the fifth circled entry in Fig. 1. Additionally, the MACD, which are the yellow bars at the bottom will signal changes in investor sentiment as the bars move down from above the zero line. Both signals would help the trader know what to do with the fifth circled failed-test.
10. We’ve shown how you can use technical indicators to guide you in the better health of setup conditions. We will cover other test setups in future posts along with the proper use of technical indicators. Much more to come.
“The road to success is dotted with many tempting parking places.”