Learning to Identify Key Setup Areas

Deliberate practice requires maximum exposure to price action and an ongoing process of learning through trial and error.

Whenever you have a spare five minutes or so, a great exercise you can do to enhance the ‘maximum exposure’ part of your deliberate practice, is the following:

• Bring up a chart of any instrument you like to trade.
• Identify the price swings which offered the best profit potential.
• Identify the best areas for entry to these price swings.
• And examine price action to see how you could have identified these setup areas.

This brief exercise (repeated over time) will develop your intuitive pattern recognition abilities, improving your ability to analyse price action and identify key setup areas in real-time.

Let’s look at an example, bringing up the FX Futures 6B chart (spot forex GBP/USD equivalent) from yesterdays session, Wednesday October 6th, 2010.

This is not cherry-picking the best chart, with a nice trending market and 100+ pip price swings. This is a choppy session with limited opportunity. This is reality.

The chart below identifies the price swings which offered the best profit potential.

And here we have identified the potential setup areas, where we should quickly examine price action for clues as to entry.

Let’s now consider each of the Setup Areas, and look for some way we could have identified entry into their corresponding Price Swing.

Looking at Setup Area 1, we note that the UK session has opened with a bullish thrust up through level A (1.5924), the previous day’s high, however was not able to sustain higher prices. The upper tails at B are evidence of selling in this area, leading to price subsequently falling back below the open. It then rallied again for a second attempt to breach the highs, at point C. The bulls at this point were not able to get price even up to the previous highs at B. The failure of a second attempt to do something, often signals the opposite about to happen. If the bulls can’t push this thing higher, it’s likely going lower. This offered a good entry opportunity (short), at the failure of the second push above the previous days high.

Price fell quickly to point D, approaching support area E (which is actually the top of an area of support between 1.5868-75 and another area just below at 1.5847-64). The downswing to D was quite strong, so it would not be wise to enter against this move. Best to wait to see how price moves from here, and how it interacts with the support level (if it should get there).

The upswing from D was initially quite strong as well, showing some good buying before moving to retest the lows. The move down to Setup Area 2 and point F was on slightly lower momentum than the original downswing to D. Interestingly though, it was not able to sustain prices below the swing low at D, as evidenced by the two lower tails at F. Had the market sentiment been overwhelmingly bearish at this point, then price should have easily broken below D for a test of the support level E. Failure to do so indicates demand (buying) entering the market just above the area of support. A breakout-failure type entry (long) could be taken on price breaking above the candle at F. We note of course that this is a counter-trend entry, so caution should be applied in trade management, remaining aware at all times of the potential for the downtrend to resume.

The rally continued though up to Setup Area 3. Point G and H showed resistance abeam the point of original trend change (point I to the left of G&H, where the uptrend changed to downtrend and trapped longs were forced to exit). Bullish momentum clearly slowed as the rally reached this level, indicating either a lack of ongoing commitment from the bulls and/or an increase in supply. Area J set up a beautiful entry opportunity back in the short direction, as price penetrated the area of short term resistance and then was driven back lower by supply, forming an upthrust pattern. Entry should be taken on the break below the upthrust candle.

Movement into Setup Area 4 offers a very similar opportunity to Setup Area 3. Short term resistance was found at K, abeam the point of break down from the swing highs at J. Candle L provided another upthrust opportunity back in the short direction.

Interesting… it seems to be all about price interaction with areas of previous supply/demand imbalance – areas of higher timeframe S/R and areas of previous swing high/low (in this case the point of break down from these swing high areas, for setups 3&4). Areas for further investigation, perhaps?

Of course, entry is just one part of the game, and certainly nowhere near the most important. Once into the trade, you’ve then got to manage it, in an effort to minimise risk and maximise any gain. Have a look at the chart again and see if you can identify appropriate targets and exit points.

Yes, it’s easy with the benefit of hindsight. But the experience we gain through examining ‘hindsight perfect’ trading opportunities will aid in our intuitive pattern recognition when trading live. It’s all part of effective learning.

Happy trading,

Lance Beggs.

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