Two Cornerstone Steps of Trade Set-Ups

“The cornerstone of my trading can be summarized in two easy steps: (1) Find the trend: Short and long term. (2) Find potential reversals within the trend."

Let’s explore this further because this is the mindset I'm in when making my trades. Now, this may sound remedial -- if not outright obvious -- but a trade is made up of three points:

An entry
Potential profit targets
Potential stop-loss levels

I use three tools to support these decisions: Fibonacci levels, trendlines and a trend indicator. Here’s an example of a typical chart:

Three tools are active on this daily chart of symbol EUR A0-FX. First, let’s look at the trend indicator plotted with the triple magenta lines. Next, we can look at the two trendlines on this chart and, finally, the Fibonacci levels on the right side. All three tools are automated and adjust with price action.

So, how do these tools help me reach a decision on my three points? I simply begin asking myself some questions; certainly not rocket science because all thinking is done by answering questions.

The first question is: Am I on the “weak” or “strong” side of the trend? This is easily determined by looking to see whether the market is trading above or below the triple magenta lines. In the case shown in this article, you can see that we are on the weak side of the trend.

Weak means that a short would be with the trend while a long would be contra-trend. When trading Forex (as you can see in the first chart in this article), I typically watch two time frames: The 60-minute chart and the daily. (A trader can watch any number of time frames. For example, 240-minute charts are another popular time frame.) If you are trading intraday, it is always wise to see if the intraday trade is with or against the daily chart trend, so be sure to check that long-term trend.

The second question involves finding potential reversals within the trend. This basically means that, to pinpoint profit targets and stop-loss levels, I must decide where I think the market will reverse. A reversal with my trading direction is a profit target while reversals against my trading direction are areas around which I will look to place stop-loss orders. Let me clarify that:

I use Fibonacci levels to accomplish this. These levels allow me to find support and resistance levels within the trend or the “last major move”. The subsequent chart shows how this works:

The Fibonacci levels on the right side of the chart show where this market is most likely to trade to and then potentially find support and resistance. With the sharp drop from the high (marked with the blue triangle), we can see that the market only very briefly stalled at the 0.500 level and then sliced through 0.618, 0.786 and 1.000.

The 1.272 Level finally brought some support to this freefall. Each level could have been a potential entry or profit target for a short. (Remember: I am only considering trade management here. These are not entry rules.)

The levels have not outlived their usefulness yet! Now, all of these potential support levels are potential resistance. Currently, we see that the 0.786 level is keeping prices from trading higher.

Think of a Fibonacci level as a tall building. Each floor is a support, and each ceiling is resistance. However, one person’s ceiling is the floor for someone above him or her. That’s how support and resistance works, so it is important to watch the levels going up and down.

I can also use these levels as stop-losses. For example, an entry short could have been exited at the 1.272 level because prices bounced there, so, now, the 1.000 level could be a ceiling (that is, resistance) and also a stop-loss if I had more of the position left and wanted to protect my profits.

Now, I have not yet discussed entries and will do so in another article. This also leads me to another point: Most trades are made or broken by the exits. Entries are the “easy” part. A well-timed exit is what oftentimes makes the difference. And, when I refer to exits, I mean profit and loss exits.

With this philosophy, there is not a single profit target because there is no single stop. These levels are supported by the price action. If a trader enters a market based on the chart, any exit -- profit or loss -- should also be based on the chart. This is why I am always searching the charts following my two step as described at the beginning of this article: “(1) Find the trend: Short and long term. (2) Find potential reversals within the trend.”

So, I hope I may have raised some questions and piqued your curiosity. Let me leave you with a chart similar to the previous one, except for with all the tools active, so you can make some decisions of your own. Check out this chart of the EUR A0-FX on a 60-minute time frame with the Fibonacci, trendline, and trend indicator and then I’ll give you a few things to focus on:

A few things to look at:

The trend indicator is neutral. See how it’s more sideways, and prices are trading within it rather than above or below it?

The 0.786 Fibonacci level is resistance as I explained previously. Are there other resistance levels there too?

Note the downtrend line.