In the article on technical analysis, I already explained the basics, principles, and concepts of price action trading. Today, we're taking it one step further by looking at the four basic trade setups. It's crucial to understand that all setups and trading ideas can and should be sorted into these four categories. After all, we want to know what our business is!
A brief overview: there are trends or ranges. Trends can either continue or end, and the same goes for ranges. Therefore, all trading setups can and should be categorized into one of these four categories. Let's start with the probably simplest trade setup:
Trend Continuation
Although the choice of the right trade setup should be determined mainly by psychology and personality, the first category statistically represents the best category of trade setups. Based on the trend theory, we know that trends tend to continue. We can use this principle to our advantage. The goal is to enter on pullbacks to take the next swing (which should make a new high). We all know possible chart formations that fall into this category: pullbacks, flags, pennants, triangles, and consolidations. It's also possible to use harmonic patterns in this context. If, for example, we identify the trend in the 240-minute chart, harmonic patterns frequently arise on smaller time frames, such as the Gartley pattern. Based on your individual strategy, this provides the opportunity to work out optimal risk-reward setups.
Figure 1 shows a clear uptrend, characterized by higher lows and higher highs. Therefore, the aim is to identify the pullbacks in the intact trend and enter on them.
Advantages of this trade setup: This setup is suitable for beginners and advanced traders because of its good success rate. The entry should aim for an excellent risk-reward ratio. In this context, it is essential to understand the concept of the profit factor!
Trend Termination
The second category of trade setups can also be seen in Figure 1. At some point, the swings in the trend become shorter. This means that although we are still making new highs, the momentum is decreasing. We see shorter upward stretches and deeper pullbacks. Therefore, it will naturally come to a point where we see a lower high, which is a first warning sign. So, if you are still long at this point and see further signs of a potential trend reversal, most of the position should be closed. There is nothing worse than giving back all the profit.
Why should I know what a trend reversal looks like?
As mentioned above, this is part of your business! If you trade the trend continuation, you should study reversals to make better decisions about when to take your profits. Of course, it's also possible to short at these points and profit from falling prices. This seems dangerous at first, and you're not wrong about that. Therefore, several points should be addressed in the respective strategy that increase the likelihood of a potential trend reversal. Nevertheless, we can also argue with the profit factor here.
If you lose more frequently but have a much better risk-reward ratio, this strategy can be just as profitable or even better.
Back to the actual setup. The term termination in English is more appropriate than trend reversal. Why might that be? As you will see shortly, there is a classic cycle. From the trend to the range and back again. If we catch the high and correctly predict the downward movement, there may be a trading range at this level for now. Only after that, when the range breaks out, do we follow with lower lows and lower highs? Therefore, this category of trade setup requires some prerequisites for the trader. The trader needs a high level of patience. This is essential to avoid shorting in every upward movement in the trend and always being stopped out. Accordingly, we can see that a clear system and suitable filters must exist, indicating a termination. Discipline is also a major factor. We must be disciplined when we are wrong. We must be disciplined to stop ourselves out when we are wrong.
Conclusion: This trade is difficult from a psychological point of view, and is therefore really not suitable for everyone. Nevertheless, we should study examples where a lower high with subsequent trend reversal occurred to better manage our long positions.
Support & Resistance Holding
Up to this point, we have learned about two categories of trade setups. Most likely, we will find that a trend ends when either support (downtrend) or resistance (uptrend) holds. At this point, you can already see a cycle. The beautiful thing about the cycle is that you know where you come from and what is very likely to happen next. You're prepared! This is a big advantage. Most traders don't know this. They have a setup, but don't even know why it works. This is simply negligent and the fastest way to end a career. Back to the setup: we hold previous support and resistance levels. It leads to a sideways phase between these levels. The idea is, therefore, always to buy when we are at support and vice versa. It sounds simple at first, but it's not so easy. We often expand the range and form new relevant support and resistance levels. Furthermore, we don't always run cleanly between both marks. Therefore, it's difficult to realize profits.
Therefore, it would often be correct to produce profits in the middle of the sideways phase, but sometimes not. You can see that it's not easy to trade this setup correctly and consistently profitably! Therefore, it's worthwhile to be patient during these ranges and profit from the breakout of the range. This type of trade setup represents the fourth and final category.
Support & Resistance Breaks
This class describes the breakout from sideways phases, which were trendless. Here, we must concentrate again. In the 1st category, we also continuously break support and resistance levels. The difference is that we are in a trend there. Therefore, the breakout from trendless sideways phases is a category in itself.
Trading breakouts can also be very difficult. Some breakouts go briefly in the anticipated direction before turning strongly. Others, on the other hand, initiate a strong and long-term trend. Therefore, it's essential to understand the four categories to read the market effectively.
Therefore, it's worth taking a look at Figure 4. Therefore, breakouts initiate trends until trend termination. We then often move into sideways phases before leaving them and returning to a trend.
Summary
- Trend continuations are the easiest and best trades.
- Trend termination trades offer excellent risk-reward ratios but are only recommended for experienced and disciplined traders.
- Trades in sideways phases are often difficult to trade.
- Breakout trades can initiate new trends. Nevertheless, special focus should be placed on risk management to distinguish functional breakouts from fakes.
- The phases usually alternate one after the other. Therefore, we can mentally prepare for the next phase.