Building up a system of trading is one of the first tasks you have to overcome when you start learning to trade. However, the process doesn’t end there – indeed, it never truly ends because you will forever be developing, perfecting, honing, and adapting your trading system. The most basic building blocks of your system are likely to be the trading setups you have selected and integrated into your process.
A setup is a specific combination of price trends and movements that, in given market conditions, has a high likelihood of delivering an expected outcome. Every setup basically identifies certain market conditions that mean a trade is likely to succeed.
What Kind of Setup?
Forex traders come in all shapes and sizes and from all walks of life. People get into forex trading from just about any profession you can think of. Some start out as floor traders or market makers but others go into retail trading from their regular jobs, as a way to make some extra income or as a way to replace a job or profession in which they are unsatisfied.
Moreover, there are no real limits to the different ways it is possible to make money through forex trading. But, here’s the catch, you won’t be able to do many of them. Not because you aren’t smart enough or gifted enough but because they won’t suit your personality and your strengths and they will eventually frustrate you. This is not a comment on your abilities so much as it is a description of the fact that everyone will end up trading in their own very unique way. If you try to teach an impatient trader how to watch the market for weeks at a time, waiting for a rare set of circumstances to occur, they are going to struggle and eventually fail. The same can be said if you push a risk-averse trader to make high-risk, high-tempo decisions under pressure. They will become frustrated and ultimately they will fail.
Because forex traders come from different backgrounds and because trading is such a personalised skill, it is important to identify what kind of trading suits you. In many ways, it is the ultimate personality test. A teacher, mentor, or instructor may be able to show you a whole series of setups and will probably place an emphasis on those that suit them but, at the end of the day, you will need to figure out what works for you. You will end up making your own, unique style.
There are a couple of things here that are important to understand. Firstly, when you are starting out you will have a hundred questions about whether you should stay in a trade longer or shorter, whether you should enter earlier or later, and so on. The fact is that nobody can tell you based on one situation. It takes a much larger sample size – dozens or tens or even hundreds of situations – to reveal what works. And over such a long timeframe, what is revealed is not just what works better but what works better for the individual trader.
Everyone prefers to trade at different times. Some people have day jobs that mean they can’t trade early in the morning, others will want to trade at 4 am. Some people will have conservative position management strategies, others will be risk-takers. But the key thing is that if you try to apply an approach or strategy that goes against your needs and strengths, you may have some initial success but over the long term, you will deviate from it, twist it into something it isn’t designed to do and it will cease to be a system. In the worst case, it will cease to function at all and you will fail.
Once you do figure out what works for you, an important next step is to codify the information and start turning it into your own process.
Making Your Own Setup
Why is it important to write down your setups? There are several reasons. One is that you will probably be running several setups at the same time. Perhaps not at the beginning but eventually your strategy will include a plethora of setups that you have shaped and integrated into your system. Keeping all of these in your head is going to drive you nuts but, even if you can remember them all perfectly, you are more likely to make a mistake if they are not written down.
But there is a more important reason and it has to do with clarity and systemization. In your head, your thoughts are nebulous and hard to pin down. You may feel like they’re crystal clear but the real test of that is if you can convert them into words, into language and, even better, write them out. It doesn’t matter if when you write them down you are the only person that’s able to figure out what you meant, the act of writing down your thoughts makes their meaning crystalize. This is a crucial step in establishing a workable and consistent trading system. Clarity and systemization.
The actual process of writing out a trading setup is made much easier if you use a setup sheet. You can conceivably make your own but there are pre-made sheets out there that are perfectly useable.
Setup Sheet Blueprint
When you open up your blank setup sheet, it should include some of the following fields. Trend Analysis, Entry Criteria, Indicators, T.E.S.T., and others. T.E.S.T stands for Timeframe (how long you plan to keep a position open), Entry level, Stop Loss level, and Target or Take Profit level. Based on these Risk Ratios and other key stats can be calculated automatically. It doesn’t matter much what kind of trade you are going with, whether it’s a reversal, a pullback or an area breakout, you will need to fill in these fields accordingly.
Use the Trend Analysis fields to describe the market conditions that need to be taking place when you are looking for the setup to emerge. The conditions you are entering here are going to depend on the setup you have selected. In which direction is the market trending? Are you looking for it to be making new highs? If so, on what timeframe?
The Entry Criteria fields are where you write precisely what the price should be doing when the time is right to enter. If you are looking for it to break out of a consolidation, how long should that sideways movement last before the breakout? Are you looking for a low base or a high base? Are you waiting for the moving averages to approach and put pressure on the price to breakout?
You should fill out the Trend Analysis and Entry Criteria in language that you will later be able to understand. Again, it doesn’t matter if it makes sense to anyone else so much as it matters that it will make sense to future you. Under Indicators, list the indicators you will be using to help you identify the correct entry point and under T.E.S.T. enter your timeframe, stop/loss, and profit target. Remember, the first time you fill out a setup sheet for a given setup is not even close to being the last. The reason for this is that once you have these fields filled out with the criteria for your setup, it’s time to take it to the test range.
Tried and Tested
Until you test the setup you’ve outlined, nobody in the world can tell you if it’s going to be any good. What’s more, if you’re not testing your setups, you are going to struggle to make it as a trader because throwing them in the deep end is probably going to hurt you financially. All that is to say that testing is a fundamental activity of a smart forex trader. If you’re not testing, you’re not improving and your craft will stagnate.
There are several ways to put a setup through its paces. You can run tests in a simulator (TradingView replay feature) or through a demo account. Both have their advantages. Using a demo account is a real-world test (but remains risk-free) and has all the advantages that this entails but it can take a long time. This is particularly true if you are testing a setup that doesn’t occur with any great frequency. It can sometimes take months to build up a viable sample size for your test to yield any useful data. In that sense, simulator testing is much quicker and will give you a rough indication of how your setup performs.
Regarding sample size, opinions differ. However, you will want to generate a minimum of twenty times you traded with your setup to have a good enough dataset from which you can gauge results.
Test and Adapt
To be thorough, your testing process should have several stages. First, test your setup in a simulator and assess whether it yields a reliable win/loss ratio and lucrative reward/risk parameters. That is, are you winning often enough, and are the wins rewarding enough compared to the losses? Once your setup passes this first round, take it to your demo account and test it there. This will naturally take a lot longer but be patient. It is important to give every setup a proper real-world run-out.
Once you have been through at least these two stages of testing, you will have probably noticed changes you would like to make to your setup sheet. The first version of your setup is bound to have deficiencies that emerge when you run it through testing and your experience will also have improved to the point where you can see what can be changed. Feel free to tweak the trend analysis or entry criteria or any other aspect of the setup if you feel this would make a qualitative difference to how the setup performs.
To be truly thorough, you should then take this amended setup sheet back to the testing range. You can also run historical tests. That is, you can take your setup and check it against a given currency pair’s historical price charts and see how it performs in a real-world scenario. The advantages of historical or backtesting are (1) that it is quicker than demo testing and (2) can give you an insight over simulator testing, especially because you know or can crosscheck the news events that might have impacted market movements.
Designing a setup is a two-step process (writing out a setup sheet and testing it) only on the surface. The reality is that your setups will evolve over time, even after they have successfully gone through testing. They will evolve with you as you grow as a trader. With that in mind, don’t throw out your old setup sheets, hold onto them because you might find that your trading habits change over time and you might want to resuscitate them from the reject pile. With a tweak here or there, of course.
Bear in mind, also, that there is such a thing as too many setups. Focus on those that work for you specifically and that you can successfully integrate into your system. You will be a better trader if you do not spread yourself too thin.