Trade Setup Guide
Trade Setup Guide
In this guide, I will outline my process for finding trades and I will give examples of the trade setups that I trade.
Every trade setup will need to have confluence. This means that multiple factors need to align in our favor in order for a setup to be valid to put on a live trade.
There is confluence when the following parts, known as TLS, align:
I only trade when at a minimum two of the three parts align. Below is an example (see fig. 1) where there is an uptrend on the AUDUSD and then a signal forms (bullish engulfing candlestick pattern) on a significant level (horizontal and dynamic) indicating a possible long opportunity.
The first step we take when looking for trade setups is to identify in what market we are in. Is the market trending, going sideways or are we in a choppy market?
Basically, there are three ways we use to identify the market type we are in:
- Obvious Patterns
- Price Swings
- Moving Averages
The first way to identify the long-term market trend is to simply zoom out the chart and see how prices are moving. Are they clearly going up, or down, or sideways. Do not try to be fancy here. The most obvious direction will give a good first indication of the long-term trend (see fig. 2).
If we analyze the chart a bit more we can see that the following story developed in the past year for the Forex pair USDCAD (see fig. 3): Overall the market stepped higher with a period of consolidation in November and December of last year. Although the long-term trend is clearly up, the pair has been moving lower in the past three months, so the mid-term trend is down or bearish.
The second way to identify the market trend is to look at the highs and lows of the price swings.
- Trending markets will make higher highs and higher lows in up-trending markets and lower lows en lower highs in down-trending markets See fig. 4. If we zoom in on the previous chart and analyze the mid-term downtrend, then we see almost consistent lower highs and lower lows were formed.
Fig. 4: USDCAD Daily Chart down-trend
- In sideways markets, the highs and the lows tend to form on the same levels. The levels are confirmed after the second bounce. We can trade of the third bounce. The more bounces we have had the more like it is that the next approach to the level will be a break of that level. See fig. 5.
Fig. 5: USDCAD Daily Chart, Sideways range-bound market
- Choppy markets are markets that have very compressed price swings. It is best to stay out of choppy markets.
Fig. 6: USDCAD Daily Chart, Choppy market
The third way to identify the trend is by using moving averages. For this, we will use the 8 and 21 periods Exponential Moving Averages (EMAs).
- If the 8 EMA is above the 21 EMA and the 21 EMA is sloping up, then the trend is up.
- If the 8 EMA is below the 21 EMA and the 21 EMA is sloping down, then the trend is down.
- If the EMAs are diverging then the trend is getting stronger
- If the price is moving away from the EMAs then the trend is getting stronger.
- If the price is far away from the EMAs this can indicate the trend is overextended.
- If the EMAs are more or less flat and continuously crossing each other and if the price is close to both EMAs, then we are in a sideways or possibly choppy market.
How to Trade The Trend
Once we have identified the trend type we can trade it in the following ways:
- We can trade with the up and down trend using breakout or reversal setups.
- We can trade counter to the up and down trend using reversal setups.
- We can trade outside the tops and bottoms of a sideways trend using breakout setups.
- We can trade inside the tops and bottoms of a sideways trend using reversal setups.
- We stay out of the market if it is choppy.
We always want to trade of-of significant levels in the market. We will use two kinds of levels:
- Horizontal support and resistance
- Dynamic support and resistance levels 8 and 21 EMA (50 EMA and 200 SMA)
Horizontal support and resistance
Horizontal S&R are areas on the chart where historically prices have bounced of-of. We can call them historical swing points. Quite often they are seen at round numbers as that is where many traders tend to place their orders. When drawing in the levels we will follow BCW to prioritize the importance of certain levels:
Bounces of the candle bodies (open and close prices) are most significant.
Many time levels line up with previous areas of price congestion.
Bounces of the wick are important but less significant than body bounces or congestions areas.
Dynamic Support and Resistance
Dynamic S&R are formed by the moving averages. More often than not the price will respect the 8, 21, 50 and 200 EMA.
We will be looking for price action signals in the form of candlestick patterns on identified price levels and in the context of the overall market (trend).
These are the candlestick patterns we consider trading:
- Inside bar / Harami
An inside bar is a pattern formed by two candles. The second candle has an open and a close that fall within the range of the open and close of the first candle. Also the high and the low of the second candle fall within the range of the high and low of the first candle.
- Pin bar
A pin bar shows a rejection of a certain level. The story is that price moved in a direction, but then moved in the opposite direction on the same day closing around the same level as the day started.
- Engulfing pattern
This is a two candle pattern where the second candle engulfs the first candle. Meaning: the second candle has small wicks and the range of the second candle covers the range of the first candle. This pattern shows that there is momentum and conviction in the direction of the second candle.
- Fakey pattern
This pattern is formed when an inside bar breakout fails. The price will move in the opposite direction of the breakout after this pattern.
- Tailed bars
This pattern looks like a pin bar, but with a larger body. Like the pin bar, it shows rejection of a certain level but in a less obvious and less powerful way. More often than not we can see several tailed bars form on a level before price reverses of that level.
- Anchor bars
These are also called momentum bars. These are bars with wide ranges and small wicks. These bars are signaling if a move is just a retracement or a reversal. See figure 7.
Fig. 7: Anchor Bars
Below are some examples of possible trade setups that are in line with the methods described above. Of course, these are ideal examples. Always understand and accept that these setups can and will fail.
Example 1: With Trend Inside Bar Continuation
Before the trade:
After the trade:
Example 2: Counter-trend Pinbar On Horizontal Support Level
Below figure shows how we would have identified the horizontal levels.
Then let’s zoom in and see what setup occurred.
Example 3: Engulfing Pattern in Ranging Market on Horizontal Resistance
More examples will follow. However, you can already check out my Trading Ideas to see some real-life examples.