There is a reason why this blog is called “TimelySetup” which comes from the words “Setup” and “timely”.
Setup is a set of favorable conditions which tilt the statistical probability of a particular trade to go in our favor. Strictly speaking, a trade should not be entered without appearance of a particular setup. Beneath the surface, reliable setup exists if it captures repeated behavior of certain group of market participants, e.g. how large players execute big positions, how mutual fund managers react to earnings result, or how short-sellers need to cover their positions on certain occasion. Unfortunately, we never know the motivation behind trades. However, each distinct repeatable behavior creates distinct repeatable foot-prints which become the basis of our implementation of a setup.
There are many kind of setup implementations freely available in public domain. Swing traders often rely on range expansion setup with the expectation that price will continue moving in the direction of range expansion. Pairs traders rely on deviation convergence setup with the expectation that deviation in prices of similar stocks is temporary. Darvas has a well defined setup to capture continuation of growth stocks after pullback. These setups are often implemented as a set of rules to enter a position.
Exploiting repeatable behavior of certain market players will tilt the statistical probability of a trade going in our favor. However, we must recognize that we never know whether the behavior which our setup is trying to catch is actually there. The set of rules which define our setup implementation may identify something wrongly.
There are market phase where a particular setup is likely to work best and market phase where a particular setup is not likely to work. It happens because the targeted behavior of the market players varies depending on market phase. For instance, mutual fund managers will only accumulate stocks when there are money coming to them to manage. If beneath the surface, the setup is exploiting the behavior of mutual fund managers in accumulating stocks, then this setup will work well when it is indeed the season for mutual fund managers to accumulate stocks.
That’s why awareness of market phase which are best aligned to a particular setup is very important. That’s why we execute only a timely setup.
Let’s take a simple range expansion setup which is most relevant to swing trader. This setup, based on daily data, identifies stocks which after consolidation and volatility compression suddenly shows expansion in range accompanied by high volume. We study the Long side of range expansion setup.
The graph above shows cumulative value of highest high minus lowest low for the next 4 days after occurrence of the range expansion setup. This setup, on the Long-side, obviously has an edge as the graph shows. Most importantly, it is clear that there are indeed short span of intervals in which this setup works very well as the green points on the graph show. By the way, the green point is determined without looking ahead, so we can rely on the green point to show friendly period for this setup.
Although a rising market is good for this setup, there is a subset of a rising market which is really friendly to this setup. Usually, it is not the first up leg from a bear market, but the second or more up legs after the bear market. Yes, the first up leg from the bear market is friendliest to Short-covering setup!!
The above graph show the value of this index as of Friday, 13 April 2012. I hope to share this index daily on daily market update to know whether or not it is the best time to employ range expansion setup Long side on swing trading horizon (3-4 days).
We should employ different setups on different kind of market phase.