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In previous MarketPulse articles we have been discussing in detail the steps required to create a robust and effective trading system. As a recap, a trading system is a significant part of a broader trading plan which defines the conditions through which we engage the market.
A trading system is certainly not a complete trading plan however! Getting into the market is just one of the considerations a trader must take into account when trading over a period of time. Other factors such as risk management, portfolio allocation, exit rules, and self assessment and adaptation are all far more important to long term trading success. Nonetheless, few traders will start anywhere else but in systems design. The search for the Holy Grail is on!
In the last MarketPulse article on developing a trading system we introduced the concept of a setup. We said that a setup was a series of conditions which needed to be met before we entered a trade. Traders strictly only ever enter a trade when a valid setup is observed.
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Here’s an example of a purely technically (using charts only) based setup which may trigger a system entry:
1. The size of Candle 1 must be greater than 1% of the share price and be in the colour of the prevailing trend (e.g. black candle in an downtrend and white candle in an uptrend).
2. Candle 2 must open below the open of Candle 1 and close above the close of Candle 1 for a long trade and open above the close of Candle 1 and close below the open of Candle 1 for a short trade (i.e. a ‘bearish engulfing’ pattern).
3. RSI must have crossed above 30 within last 3 periods for long trade, or crossed below 70 within last three periods for short trade, or enter after conditions 1 and 2 have been met and an RSI cross subsequently occurs.
Setups can generally be defined as trend, reversal, range, and breakout setups. If there’s another phase of the market – we haven’t thought of it yet. But generally prices are in one of these phases. The above example is primarily a reversal setup.
Reversal setups tend to be very responsive. A setup’s responsiveness will determine how much of a price move will be missed before an entry is made. Given that reversals are generally rapid changes in price direction, we’d want to use the most responsive tools available to us to identify them. We find that pattern based technical analysis tools are best suited to reversal setups rather than fundamental tools which may have a significant delay before actually affecting prices.
For reversals setups, we find that candlestick patterns are extremely useful, as are more conventional bar chart patterns such as double tops, double bottoms, and head and shoulders. Indicators such Bollinger bands, stochastics, and the MACD with timeframes less than 20-periods can be used for confirmation of the observed price patterns.
Whilst reversal setups are generally suited to those trading with shorter time horizons, of course, quite often when a reversal is made a new trend is commenced. Thus the trader may find that a trade initially entered on a reversal set up is maintained because it also ends up meeting the criteria for a trend setup down the track.
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Trend setups are generally less responsive than reversal setups because trends tend to last for a long time, and therefore the timeliness of an entry is not as important as for reversals. Also, we generally want to be pretty sure that we are actually in a trend before we enter, and thus should be prepared to trade off some profitability for certainty of the trend being in place. Trend setups are therefore better suited to those who have a longer term trading horizon.
For many traders, setups conditions may also include fundamental aspects such as price to earnings per share ratio (PE), and earnings growth. These are used as broad filters to whittle away those stocks less prone to trend. It’s fair to say that stocks with attractive valuations, and both growing earnings and a solid history of earnings growth, are more likely to trend than those who don’t meet these criteria.
From the subset of stocks generated by our fundamental analysis, we will generally then run a series of technical filters to ascertain the direction and strength of the trend. In this case, we prefer to use moving averages of a duration appropriate to the timeframe we are looking to trade, and look for confirmation from the tools such as the momentum indicator, relative strength index (RSI), and on balance volume (OBV). Generally, we are using longer timeframes on these indicators – of more than 20 days in duration.
Here’s an example of a trend setup which takes into account both fundamentals and technicals:
1. PE should be less than 15
2. Earnings in last 3 reporting periods must have increased by 10% pa on each occasion
3. Consensus estimates for 1 year future earnings growth are great than 10%
4. Price must be above 50-day moving average
5. 20-day moving average must above the 50-day moving average and rising
6. RSI must be above 20 but below 80
Really, in the above example, stocks which meet the criteria will be trading on fairly cheap price to earnings multiples, have a consistent history of growing earnings and likely to continue to do so for the near future, be in a medium to long term uptrend as measured by the 50-day moving average, and price momentum will be increasing given that the shorter term moving average is rising and the RSI is still in an expansion phase.
Setups give us better trades
Imagine if you only ever considered trades which met the above criteria? How much better would your portfolio have performed over the last 5 years or so?
Well, that’s the whole point of your setups: To try and put you in trades which have a high probability of success and which are of a similar nature each time. Anything else but stocks which fit your entry criteria will be ignored.
In each case, it is important to clearly define the set of rules under which a trade will be entered. There should be little-to-no room for discretion or interpretation – otherwise you don’t have a system! So, be very specific in defining exactly what needs to transpire before a trade signal is generated.
Be careful however to not make the number of criteria required to be met too onerous so that very few signals are generated, or so loose that too many signals of a lesser quality are generated.
We’ll investigate further in future MarketPulse articles.