Tools

💻 Introduction to Trading Setups

A trade setup refers to a structured methodology that includes a specific set of criteria used to identify high-probability trading opportunities. These criteria may be based on technical analysis, fundamental analysis, or a combination of both. The following article outlines the basics of trading setups and provides examples, based on the book Trade Your Way to Financial Freedom by Van Tharp.

Trading Setups and Trading Systems

Many traders mistakenly equate trading setups with complete trading systems.

Trading setups are not full trading systems; they are only one component of a broader strategy. An effective trading system includes several additional elements.
Setups play a key role in identifying optimal entry points in the market.
However, setups alone should not be the sole reason for entering a trade. Rather, they are conditions that must be met before you even consider opening a position.

⚙️Setup Conditions

Setup conditions are specific criteria that must be met, according to your trading concept, before opening a position in the market. These conditions are designed to increase the probability of entering successful trades. Setups may include:

• General fundamental factors affecting supply and demand

• Technical analysis signals that reveal trading opportunities (see several TA setups later)

• Seasonality patterns based on time-specific behavior

• Intermarket correlation conditions

• Any other relevant criteria derived from trading research

Fundamental conditions can form the basis of a trading setup. These conditions may suggest whether a market is fundamentally attractive or not, based on supply-and-demand metrics. However, fundamental analysis alone cannot determine the exact timing for entering or exiting a trade. This is where it becomes helpful to distinguish between the four phases of market entry:

1. Market selection

2. Trend direction

3. Setup creation

4. Timing of order execution

🎯Deciding the Markets to Develop Your Setups

Choosing the right markets for developing your setups is one of the most important decisions in trading. Consider the following criteria:

• Market liquidity – Choose active, liquid markets to ensure smooth order execution.

• Newness of the market – It's generally safer to avoid newly established markets with limited historical data and uncertain behavior.

• Market volatility – Ensure the market has enough volatility to allow for potential profits that are two to three times your initial risk.

• Market capitalization – Trading low-cap assets typically involves higher risk and higher potential reward.

• Market independency – Trading across several uncorrelated markets increases the chance that at least one market is in a strong, profit-generating trend.

• Criteria fitting – Focus on markets that have historically met your trading criteria, as they are more likely to do so again.

• Market makers – Research who the market makers are, their reputation, and the regulatory body overseeing them.

Note: According to research, low-cap stocks make up the majority of stocks that increase tenfold or more in value.

✅ Examples of Trading Setups

These are some classic trading setups that offer the advantage of limited risk. By shortening your entry time frame, you can further optimize conditions to reduce risk even more.

(1) Riding the Trend After the Retracement

Trending markets tend to generate significantly higher profits than ranging markets. Here are some key facts:

• Markets trend about 15–20% of the time; the rest of the time, they move sideways.

• Traders need reliable signals to distinguish between trending and non-trending markets.

• Ed Seykota famously said that if a trend is still obvious when viewed from across the room, it’s likely a strong trend.

You can identify trending markets using various technical analysis tools.

Example

• Identify the long-term trend by observing a sequence of higher highs and higher lows on the weekly chart.

• Use volume analysis to confirm the trend and improve the reliability of your setup.

• Make entries in the direction of the established trend.

• Enter after a pullback using tools like the Fibonacci Retracement Tool to define entry levels.

• Avoid market orders; instead, use limit orders targeting key retracement levels.

Notes:

• Avoid buying breakouts; wait for a retracement test instead.

• Trend-following signals are often followed by at least an intraday pullback—this can serve as a low-risk entry opportunity.

(2) Failed-Test Setups (of Previous Highs/Lows)

These setups focus on failed tests of previous support or resistance levels. They work on the principle that false breakouts can serve as effective entry signals, particularly when many breakout traders are trapped.

• Ideal for short-term and swing traders.

• Especially useful in the Forex market, where false breakouts are common.

• Volume analysis can be used to validate a failed test and strengthen the reliability of the setup.

(3) Closing to the Top of the Trading Range

When an asset’s price closes in the upper part of its trading range, there is a strong probability it will open higher the next day. This setup has a high reliability rate of 70–80% for an opening in the same direction.

• Offers a high-probability trade opportunity

• Enter the trade at the end of the trading session and exit the next day

• Exit quickly, since while the market is likely to open higher, the chance it will close higher is much lower

(4) Trend-Exhaustion Setups (Climax Reversals)

Trend-exhaustion setups are similar to failed-test setups but require extra confirmation that the trend is ending and a reversal is near. Basic requirements include:

• Increased market volatility

• Evidence that the price move has reached an extreme

• A preliminary reversal move in the direction of the expected trade entry

Gap Climax Move

This occurs when the market gaps to a new extreme, then reverses and closes opposite to the gap direction. It’s a risky setup best suited for short-term traders. The assumptions are:

(a) Gaps to extremes tend to be filled, and

(b) Days reversing from extremes often lead to follow-through the next morning.

How to trade the gap climax move:

• The market reaches a new extreme

• Price volatility spikes (e.g., the ATR over the last 5 days is 2–3 times the average ATR of the past 2 months)

• The market shows weakness by closing at the opposite end of the range or filling the gap on a following day

• Enter a trade anticipating a short-term move against the prior trend

(5) Volatility Breakouts (A useful setup by Mr. Van Tharp)

You can profit consistently by trading volatility breakouts, which are moves extending beyond a normal day’s price range. To trade this:

1. Measure yesterday’s price range.

2. If there is a gap from the day before, add that to yesterday’s range to get the “true range.”

3. Calculate 40% of yesterday’s true range and bracket today’s price by this amount.

4. The upper bracket is your buy signal; the lower bracket is your sell signal.

5. Enter the market when either level is hit, giving you roughly an 80% chance of profit the next day.

■ Trading Setups and Setup Examples

G.P. for TradingFibonacci.com (c) -December 13th, 2024

Main Source: “Van Tharp - Trade Your Way to Financial Freedom”