Friday, January 25, 2013

Creating a trading system IX -- The best setups

One of the simplest ways to drastically improve your performance is to trade with-trend only. Your ability to identify a trend early and enter with it is far more important than your entry type, trade management or trading style. Why is this so? The ability to sit through a trade that quickly moves in your favor and stays in your favor is far higher than a trade that gives you heat.

That is to say, you are more likely to apply your trade and risk management rules when not under stress. A great setup therefore, is the one that you are most likely to execute well. Even skilled and experienced traders may be forced into errors of judgement when their trade takes heat.

How do you choose good setups? Good setups are primarily those that have a very small Maximum Adverse Excursion (MAE). In the chart above, the best trades had very small MAE. A pleasant side effect of setups with small MAE is that you only need a small stop. If it takes out your small stop, its unlikely to make a large move.

The setups do not have to be purely stop entries. For example, b6 was the first bull bar and the first bar to close against a strong down move and is an attractive fade entry. It gave 0t MAE, i.e. did not tick against the trade even by a single tick.

However, from a predictability point of view, most sustained and large moves usually take off from bars with a strong close and are appropriate for stop entries (b11,37,46). Naturally, a strong close does not guarantee a large move all on its own (b27, b31), so we would need to refine our criteria further.

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