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Choosing Strong Setups and Filtering Out Weaker Trades

April 16, 2018 18:08

Source: Pexels

Dear traders,

Are you sometimes tempted to enter a trade that looks interesting, but deep down you are aware that the setup is iffy at best?

Ultimately, only taking trading setups that have the best odds is a beneficial practice in the long run and helps build up one's trading psychology.

This article explains how traders can avoid entering setups too early and too late… it also shows why keeping your focus high during the entire trading day and week requires discipline and a well-tuned trading plan.

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Expecting Good Things from Each Trade

Many traders are too optimistic about their setup, especially before entering the trade. They think that nothing can go wrong with their trade idea.

This expectation often turns out to be false… In fact, traders will see the price move up and down, which creates nervousness and heavily impacts the trading psychology. This, in turn, often leads to an exit at the worst, or bad, spot.

There are more issues with overoptimism... Traders often wind up entering a lot of setups and over trading because they become too attached to their analysis. This also encourages them to enter a setup too soon or too late:

  • Entering too soon is called "jumping the gun".
  • Entering too late is called "chasing the market".

Both mistakes are based on fear of missing the trade.

Don't get me wrong, developing a trading bias is key for having sufficient confidence to stay in the trade setup. But the bias needs to be built on solid foundation, not just hopes and dreams. You also need to make sure that you are not trading everything and anything.

The solid foundation is built on your experience and trading plan. Let's break this down step by step:

  1. Develop a sturdy trading plan;
  2. Test that trading plan intensively while working on the details;
  3. Focus on the best setups within that plan.

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Focussing on High-Quality Setups

This article will not dive into step 1 and 2 (trading plan), which is a different matter that requires much more detailed attention. We rather focus on providing some key tips about point 3, which is focussing on the best setups within the trading plan or, in other words, filtering out the weakest setups.

Traders can avoid overtrading and revenge-trading by focussing on the best setups that fit within their trading plan. It is also important to take trading setups that have the best odds because winning setups will help build up one's trading psychology.

After a decade of trading experience, here are my key tips for keeping the strongest setups and removing the weakest ones.

Tip 1: Use Multiple Time Frame Analysis

A setup may look very appealing on a 15-minute chart, but risky, after careful analysis, on the 4-hour chart. It is important to see multiple points of view before entering because this will remove weak setups, such as:

  1. Countertrend setups running into a reversal area;
  2. Range setups that are near support or resistance;
  3. Trend setups that are overstretched.

Let's have a look at an example on the AUD/USD. The 15-minute chart was showing a bullish breakout, but I knew from the 4-hour chart that the price was approaching a key resistance zone. I skipped the lower time frame breakout because the chance of the price breaking through the higher time frame resistance seemed unlikely.

Source: AUD/USD 15-minute and 4-hour chart using MT5 Supreme Edition from October 2017 to April 2018 and from 10 April to 11 April 2018

Tip 2: Understand the Market Structure

Traders tend to overfocus on only one aspect before entering a trade setup rather than trying to understand the overall market structure on the chart. Traders develop a deeper analysis of the market when they use the triangle of the market structure:

  1. Identifying trend and momentum;
  2. Spotting Support & Resistance;
  3. Recognising price patterns.

The analysis becomes more in-depth once traders take these three elements into account, which makes it easier to focus on the best setups and avoid the weaker ones.

For instance, a breakout on the 4-hour chart might look interesting, but if you see that the price is overstretched on the lower time frames, waiting for a pullback and a continuation first makes sense. If that retracement and continuation never happens, then you just saved yourself from a loss…

Tip 3: Wait for Decision Zones and Triggers

Traders like to anticipate market movements beforehand... But usually it is better to wait for the price to act before reacting and making decisions. Keep in mind, the market will do whatever it wants, it won't follow your trading plan.

Traders are in a better position when they try to follow the market's lead rather than hoping that the market will follow their lead (or trade position). How can they do this?

Simply by setting up decision zones and waiting for triggers to appear. Once the price reaches a key level, the market will often make a decisive break or bounce. The trigger, such as a candlestick pattern, will indicate the likely direction.

Traders do not need to trade both the bounce and the breakout… depending on your own analysis, you might only trade one of the two. But at least you will remove the temptation to trade in areas where the price is consolidating and correcting.


Wishing you a happy week of trading,

Chris Svorcik

trade forex and cfd