From the February 01, 2010 issue of Futures Magazine • Subscribe!

Failed setups: Inverse predictive power

Buyers enter trades expecting to win: they expect prices to rise. Sellers also enter trades expecting to win: they expect prices to fall. Each buyer and seller in a trade expects to win and, therefore, expects his counter party to lose. While many futures market participants may be hedging a position and therefore don’t care about the ultimate direction, they certainly are trying to execute that hedge at the best possible price. These mutually exclusive expectations are one of trading’s most fundamental concepts: You cannot enter a trade until you find someone who thinks you are wrong.

In trading, expectation and reality collide at high speed and high frequency. How you cope during these collisions determines your long-term success as a trader.

You cannot buy until you find a seller. You cannot sell until you find a buyer. Sometimes you will be right. Sometimes your counterparty will be right. Perhaps sometimes you both are right, but one of you is off on your timing.

When your counterparty is right, join him. When reality counters your expectation, go with reality. If your trading approach says price should go up, but price goes down, sell. If your trading approach says price should go down, but price goes up, buy. When your analysis says one thing, and reality says another, reality is right every time. The best traders are able to switch from offense (taking a position) to defense (taking a loss) and back to offense (reversing your original position) without hesitation.

A good defense includes risking a small predetermined percentage of your account and using stop losses. If you fear leaving standing stops in the market you should have a mental stop loss and use it when that level is hit. If you are wrong about a trade, these tactics ensure loss control.

Another tactic is to restrict your trading to specific price setups. Until you see one of your selected setups, stay in cash. This limits your exposure to situations you already have studied and experienced. Trade only on ground of your choosing. Wait for price to trigger one of your setups; enter the market accordingly and take your profit.

When a price setup succeeds, it will condition you to trade during that setup. Depending on your strengths, expand the number of setups you follow. If a setup fails, then proper risk controls will cushion the loss. You will have a moneymaking machine that balances expectation and reality.

The time will come, however, when even your best setup will fail. Whenever something you have come to depend on turns on you, it can be emotionally and financially traumatic. Built-in safeties can limit the pain, but when a trusted setup fails, it can throw you off balance for days, weeks or months.

One way to cope with a failed setup is to change your perspective. When everything you know says a market should go up but it goes down, that is a setup, too. In other words, for every setup that you follow there is a corollary setup. If you follow a single setup then you are in effect following two setups. The first is when the setup succeeds and price follows through in the predicted direction. The second is when the setup fails and price moves in the opposite direction. A follow through has predictive power and its corollary, a failure, has predictive power.

Say a setup succeeds. You run with price. You make money. Say a setup fails. Price runs in the opposite direction. You limit your loss. If price continues to run in the opposite direction, you reverse your original position and you run with price. You need to train your brain to recognize that a failed setup is an inverse setup with inverse predictive power.

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