Trading Setup – How Do You Know What to Do?
A trading setup is the research and work you do to make decisions on what to trade, and what direction to trade. This is different than your trading screen. A trading screen is taking part of the setup criteria and building a screen to narrow down what to trade. So you will need to have both and they do somewhat overlap.
Here is a link to a website I use frequently to help me with my screening and setup criteria. GuruFocus
There are a number of ways to design a trading setup. It is important that your setup is designed to fit your trading system. For example, it would be hard to develop a system that is based on swing moves of 10% or more if you are only looking at companies that only tend to move 10 to 15% a year. On the other hand it would be equally as hard to build a long-term position trading system with smaller more volatile stocks. The best way to describe this is to relate it to shooting. It would be awful hard if not impossible to shoot a .410 shotgun with 12 gauge shells or vice versa. Your trading system will work best when you load the right securities.
How do you know what to do? This is a very important question that needs to be answered as you develop your overall trading system. This starts with understanding your trading psychology. Understanding your trading psychology drives everything. Once you understand how you tick then you will have a better understanding of what type of securities to trade, which impart will help you design the appropriate trading setup.
Here are some general criteria to use when developing your trading setup. These criteria can be used a number of different ways. When it comes to developing any part of your trading plan including the trading setup it is important to use common sense. Does it make sense to use momentum criteria if you are looking to for deep value trades? The answer is “no”, so make sure when you are developing your trading setup that it makes sense for what you are trying to accomplish.
What to Trade?
These indicators will help you answer the question what to trade. This can be as broad as what market to trade to as narrow as to what position to trade. Remember the trading setup is everything that you do up until the point that you pull the trigger.
Relative strength indicator – This indicator can help you a number of different ways. You can use it to identify which areas of the market you would like to trade. You can build different types of algorithms to calculate what you want to see. For example, you want to buy stocks within sectors that have a RSI of greater than 50 you can build a spreadsheet to calculate the RSI (relative strength indicator) for each ETF for a side-by-side comparison. Then you develop a range for when you think it’s most appropriate to trade. You can use this to tell you when you should be looking to take long or short trades for your system.
This works real well for Global Macro portfolios that try to take advantage of the strength in the global market. ETFs work great for getting that type of exposure but limiting your systematic risk. Systematic risk is the risk of the company making bad decisions or doing something dumb while the sector is still doing well.
Using ETFs can give you better diversification when it comes to portfolio management. This can help when it comes to position sizing. One of the initial mistakes I made when I started thinking about trading ETFs was that I would not be able to make as much money as trading individual stocks. Well this may be true from a trade by trade basis, but when you apply position sizing you can build a more consistent trading system with ETFs. This will allow you to develop a more aggressive position sizing model to reach your trading objectives. So ETFs can be a great way to build your trading system and here is an excellent way to create your trading setup.
Here is an example of a way that you could build a trading setup using the relative strength index (RSI). The screen uses 30 day and 120 day RSIs to give you a short and longer term relative strength picture. The setup for these trades is based on the ranges that you build into your algorithm. It also uses the VIX to identify whether you are in a quiet or volatile market. The point behind this setup is to be able to identify strongest and weakest parts of the market and what type of market condition you are in. Once you have identified these conditions then it becomes easier to choose the most appropriate trading system to trade.
Fundamental Criteria – Here we are getting into more of the criteria you use to screen for the individual positions. This is where the trading setup and trading screen overlap. These criteria are considered part of your setup. Remember everything you do to help you identify what to trade is part of your setup.
These are just a few examples that you can use to build your trading setup which will feed into your trading screen.
Momentum / Growth Fundamental Criteria
- Price to Earnings divided by 5 Year Estimated Growth Rate
- Current Quarterly Earnings > Previous Quarterly Earnings
- Current Annual Earnings > Previous Annual Earnings
- Return on Equity
- Year over Year Sales Growth
- Return on Invested Capital
Value Fundamental Criteria
- Price to Book Value
- Price to Free Cash Flow
- Long term liability as a % of Capital
- Dividend Yield
- Price to Enterprise Value
Qualitative Criteria – This is one of the most overlooked areas of trading.
Qualitative criteria can be one of the best indicators to help you decide whether the long term trend will continue. This may not be as important for swing trader as it is for long-term and position traders. This type of criteria mainly focuses on the management of the company. Here are some questions to ask when looking into the management of a company.
- How long has the CEO been involved with the company?
- Have the fundamental numbers been improving since he/she has taken over?
- Is there any previous history of the CEO running other companies?
- How did he/she do in the past?
- What type of ownership does the executive management have in this company?
- Are they selling or buying?
- Do they issue large amounts of stock options?
- Is the company buying back company stock?
These are some of the questions that you should be able to answer before you decide to take a longer term position in a company.
What Direction to Trade?
Moving average indicator – This is a simple but effective way to answer the question of “What direction should I trade?” For example you could use short and long term moving averages to help you identify the most appropriate time to take a long or short position. Let’s use a 20 and 40 day simple moving average. This can be a simple moving average or an exponential moving average, the choice is up to you and what you feel most comfortable using. When the 20 day is above the 40 day, you’re looking for long positions. When the 20 day is below the 40 day, you’re looking for short positions.
Moving averages are trend trading indicators and should be applied to a trading system that is developed to take advantage of trends. This goes back to understanding what type of trading system you want to develop and how to build the trading plan to execute your system.
Longer term trend – Depending on what type of trading that you employ you should always make sure the longer term trend is also in your favor. For example, if you are a swing trader and you tend to only be in a trade between 3 to 10 days, then your longer term trend may be based on a 6 month chart. Are you taking a trade in the direction of the 6 month trend? If you are a long-term trader or position trader and you typically hold a position for 10 to 15 months, then your longer term trend may be based on a 5 year chart. Is the trend in the direction you are trading?
Highs and Lows – In a healthy market you typically see higher highs and higher lows as the market goes up. So as you build your trading setup, you may want to include a criteria that only lets you go long if the current high is higher the previous high and the current low is higher than the previous low. Or if you are going to take a short position, then the current high should be lower than the previous high and the current low should be lower than the previous low. Adding these criteria to your trading setup is very helpful when you are developing a swing trading system.
Newsletters, Investment Publications, or Blogs – If you find a good resource then you can rely on them to let you know when to be long, short or just out of the market. My only caution on this strategy is to have some sense of why they are making the directional calls. It can be very hard to continue to follow someone else advice if you do not understand their reasoning. I like to read the Investor Business Daily. It fits my trading personality and does a good job of keeping me informed on the broad market.
Here is an example of a spreadsheet that I built to keep up with my trading setup.
These are all ideas to help you build your own trading setup. As stated in the beginning it is very important that everything you do fits your own trading style and personality. This one point could make or break your trading.
Building a trading system can seem to be a daunting task but just keep focused on each step and before you know it you will be there.