The Description Of A Trading Setup

The description of a trading setup can be as simple as “When a stock hits a new 52 Wk high, then…” – Or – As complex as one that requires four or more conditions to occur.  A Trading Setup is a description of ALL conditions necessary for an Entry Signal to fire.  In the trading systems we evaluate, we try to keep the number of conditions for an entry signal to a minimum, normally no more than 3.  This is intentional, but we will leave the details for this decision to another article.  Suffice it to say, you never want your trading system to be overly complex.

And about Trading Setups — never just search for “Trading Setups”.  In order to be useful, a trading setup MUST be part of a Trading System.  If you don’t have the rest of the system, a trading setup is no good to you.  If you want to see a list of the necessary elements of a trading system, check out the first part of the article “Your Trading System – Which is More Important – The Entry Signal Or Exit Signal“.

Probabilities Of A Trading Setup Decrease Over Time

The probability of any Trading Setup being a successful indicator of the future decreases over time. This means a Trading Setup could be 75% reliable for the next 3 days, but if your system has you holding a position for 6 weeks, the reliability of the entry signal might decrease to 55%. And if you were considering holding the position for a year or more, the Trading Setup’s probability of success could be all the way down to 25% or lower.

Now, normally the success rate of a particular Trading Setup is not quoted in the “number of days” –   instead – it’s quoted in the context of a trading system.  However, if someone gives you a particular setup’s probability of success, you need to ask a lot of questions before you can really understand the whole trading system they are referring to.  Without the complete picture, the statistics you were given are meaningless – like an unfinished thought.  “I think John should” – has no meaning.

Example – Candlestick Pattern Trading Setup

Back in the day, before I actually began to investigate the probabilities for Trading Systems, I used to trade based on candlestick patterns.  A candlestick refers to a particular way of graphing the price activity of a stock for the day (or any time period).  A basic explanation of a candlestick is to draw a vertical rectangle between the Opening price and Closing price of a stock for the day. Then draw a vertical line above the box to the high price for the day and draw a vertical line below the box to the low price for the day.  The color of the candle and whether the rectangle is filled in – are all based on whether the stock “Closed” higher than it “Opened” for the day.  Thus you can easily tell just by looking at the color and size of the candle, whether it was an up or down day and how the stock likely traded during the day.  You can tell a lot about a trading day from its “Candle Pattern”.  For more detailed information on Candlestick Patterns, there is plenty of information to Google or you can check out this book High Profit Candlestick Patterns on Amazon.

The Hammer Trading Setup

The particular Candlestick Pattern I would like to talk about is known as the Hammer. A Hammer has a very small body to the candlestick located right at the top and a very long tail below the body.  It’s called a Hammer because is actually looks like a hammer standing on its end.  This particular pattern is only called a Hammer when it is the lowest and last candle within a  multi-day pattern of decreasing prices.

The significance of the Hammer candlestick is:

• The day’s trading opened near the high for the trading day,
• Trading during the day drove the price significantly down,
• But before the end of the day, the price fought all the way back up to the top of the price range for the day.

This can be a very strong signal for trading and is considered by some to be a “Trading Setup” all on its own.

Now based on what I just described to you above, this “Hammer” sounds like a pretty good setup and maybe you should trade it whenever you see it.  Problem is, Hammer’s can look pretty good on the day they happen, but then something else comes up and trumps the price action and the price continues lower the next day.

Example – Hammer Trading Setup

The above image shows our first example of a Hammer trading setup.  There is a downward trend of prices ending in a Hammer.  However, you can see by the next image that this trading setup didn’t amount to much and the pattern reversed after a 2 day rise.

 

Since the above continuation of the first trading setup didn’t quite work out, some might say A) that the descending price pattern really hadn’t gone on long enough for a Hammer pattern to be meaningful and B) the volume really wasn’t high enough for this Hammer candlestick.  My point is – if A and B above are necessary – then these conditions are a part of this “Trading Setup’s Description”.

Okay, for the next Hammer setup above, the high volume Doji (looks like a spinning top) on the previous day would indicate an agreement that the price seems to be fair.  This was followed by a Hammer the next day where the open was right near the price level of the Doji, the price was driven down, then rose right back up again to “close” near the same price as the previous day’s Doji.  To me this looks like a really strong indication that this price drop may be over for the time being.  A strong buy signal – Right?

Well, I would say that it probably was a decent trade setup, but it didn’t work out, because remember, it is only “Probable” that a Hammer Trading Setup will result in a good Buy Signal.  How probable is it?  We don’t know because we really haven’t tested the Hammer as part of a trading system yet.  Also note with the previous setup above, the Hammer didn’t actually indicate the end of the trend.  It was,  however, only 6 days prior to the end of the price drop (at least for now).  Finally note that the actual bottom did not have a Hammer for it’s pattern, but actually another Doji — meaning Hammers don’t always mark the bottom of a price swing.

As for the last Hammer pattern in this chart – this Hammer pattern occurred just last Friday.  The stock we have been looking at is HBM – HudBay Minerals and the date of this last Hammer was January 31st, 2014.  The volume during this latest price drop has steadily risen each day, with pretty strong volume for the Hammer day.  Again, unfortunately, the price pattern didn’t work out. Yesterday (Monday) the price dropped even further along with the rest of the US market after more disappointing news.  Below is the chart for the entire time period discussed above – approximately six months.

 

Now please don’t go out and buy HBM because we used it in this example.  The only reason we chose it is because of the Hammer pattern we found last Friday, nothing more.  And we chose it last Friday, not yesterday or today.

Even if the Hammer pattern had worked out this time, there are still many questions that need to be answered before you could even consider evaluating the probabilities for a “Hammer Trading System”.

1) Does Volume really matter for this Trading Setup – if so – What is the criteria for Volume?
2) Does the size of the tail for the Hammer matter? Does the price have to drop 1% or more? How much?
3) Is a confirmation day required for this Trading Setup?  What is required?
4) Where is the stop loss to be set (typically, that would be set a little below the bottom of the tail of the Hammer – but then again – that’s where everybody sets it)
5) Does the stop loss trail behind?  How does it work?
6) What is the successful exit strategy that goes along with this Hammer Trading Setup.  Certainly, it can’t be another candlestick pattern.  And most times there’s no volume crescendo either. There is no guarantee that any particular pattern will occur during any one market swing – So what is the exit signal used?

Other questions that don’t necessarily impact the Trading Setup’s probability, but that should be ask in order to understand the system better are:

- Is this a Short-Term, Intermediate or Long-Term Trade – and how do we know? (Note: for it to be a Long-Term trade, you are basically “Calling the Bottom”)
- How often should I expect this trading setup to occur during the course of a year?
- Does the Position Sizing used need to be different for this type of a Trading Setup?

I’m sure if we actually developed a “Hammer Trading System”, there would be a couple more questions applied to the system.  But the above is a pretty good list of the questions you should ask if someone quotes you a success rate for a Trading Setup.

Just remember – If someone quotes you some statistics for a Trading Setup – That’s when you need to start asking the questions.

You Like? Please share! Questions? Put them in the comments below so everyone can learn. Thanks, Gene