Define Your Setup
For a trading system to be successful, you must have Setup parameters that aren't stupid.
That may seem crude, but I can tell you I know a stupid Setup when I see one.
Let's take a look at a few:
- I like the company
- It just broke out
- It's undervalued
- Forming a bull flag
- The selling isn't over yet
- It's resting, wants higher
- It's overvalued
- We've gone too high, too fast
I know all about Stupid Setups because I've used them in my trading many times before.
We know Stupid Setups don't work... but why?
- Descriptive, not prescriptive. There is no objective measurement to test the trade setup.
- There's no exit criteria. If an asset is overvalued, it can get more overvalued. That cannot be the only reason for entry as you don't have any way to tell when you are wrong.
- You can't size up. Position sizing is crucial when trading, and if you don't know how your risk relates to the current setup, you don't know how much size to put on.
If you think you have Stupid Setups that are way too vague, there is a simple way to fix them.
By using the 5 Whys.
This methodology was first developed by the Toyota Motor Corporation for evaluating manufacturing methodologies.
Well, you're trying to manufacture trading profits, so it should crossover failry well.
What's so powerful about the 5 Whys is that it forces you to look deeper for the true Setup in a trade.
I'll tell you personally that it's incredibly frustrating to try and get to the 5th Why when explaining a trade setup.
Let's take an example:
Setup: The stock is overvalued.
The current price to earnings ratio is too high.
The buying pressure from all the hype has led to a huge move in the stock and it's not justified by the current profits the company is able to produce.
New competitors have come into the market and are commoditizing the company's product. The current sales channels are already saturated and there is no more opportunity for growth.
The product is commoditized because the company's marketing did a terrible job associating its brand with the product. The current customer base is tapped and unless there is some new innovation or a shift in vertical the company will not grow earnings.
Because f*$# you, that's why!
Notice the further down we go, the harder it is to justify the position.
That doesn't make the trade a bad one, but putting it through this kind of rigorous process will give you a better outcome over time.
Because each why gives you quantifiable measurements.
For the previous example, we now can develop reasons why the trade thesis may be invalidated.
Reasons the trade is invalidated
- If earnings growth continues.
- If products from competitors flop
- If margins stay high due to proper branding
- If the company finds a new vertical to acheive a new sales channel
- If a new successful marketing campaign comes on board
Do note that "depth" tends to go further with fundamental analysis than technical analysis. This is because FA is much more qualitative and descriptive, while much of TA already has prescriptive and objective models built in.
In other words, with TA you know when you are wrong.
Let's take a TA example:
Setup: The stock is going higher
The trend is up and it hasn't made a move in a month.
The 50 day moving average is rising and the 20-day Bollinger Band has been contracting for a month and is just starting to see its width increase.
Another feature of the 5 Whys, especially when using technical analysis, is that you can now ask if there's any hard numbers to back up your trade.
If your Setups are based off tea leaves, planetary alignment, and animal spirits, fine. But have fun rationalizing that to yourself.
Also, Setups need to be simple enough to explain to someone who isn't a trader.
If you can't sit down with someone who knows little to nothing about the financial markets and explain why you're putting money at risk in a company or a trade, then odds are you shouldn't be in the trade to begin with.
Don't have a Setup?
I've seen this problem with many new traders. They're just starting off and they want to get that "one quick fix" that will make them a great trader.
It's a process, not an endgame.
But in terms of getting started, I have developed a fully comprehensive option trading system.
Not only will you get the system, you receive full video training explaining the setup in full as well as how to execute on the trades.
After you learn the system, you will be able to screen for a handful of stocks, setup your alerts, know exactly what options to trade and how to position size.
Nothing has been left out.
OptionBounce is a great place to start for new option traders, learn more about it here.
In the next section we will talk about exactly what you are bullish or bearish on. Keep an eye out for the next email.