How to Identify The Highest Probability Trade Setups

David Frost // Blog


January 21  

While day trading can be profitable, most novices struggle to find consistency. All trades boil down to three elements, regardless of the style.

trade setup

Learning trading on your breaks the best of us. You open a book to find thousands of indicators. Chart patterns seem easy. Yet, no two people see them the same way. Try picking where to start. There are dozens of markets and thousands of stocks.

What do we do? Turn to the internet. We encounter as many trading strategies as stars in the sky. Some of them are legitimate. Some are scams.

Why is it so difficult? Honestly, people overcomplicate trading. While the nuances take time to learn, every good trade consists of three components: the setup, context, and trade management.


All good trading starts with a setup. A setup is a repeatable pattern. When you combine the set up with the other characteristics, you consistently make money. Setups come from chart patterns, indicators, and cycles, among other price action related movements.

Let’s look at the four different types of setups that exist.

1)      Reversal – Trading reversals attempt to pinpoint when a stock turns around. You aim to pick off as close to the high or low point of a move.

  • Indicators: Oscillators, support and resistance level, Fibonacci retracements, moving averages, and candlestick patterns such as Doji, outside candles, and others work as reversal indicators.
  • Pros: Reversals allow you to trade close to your stops (close to risk)
  • Cons: However, it is difficult to achieve high win rates. They’re also tough to define targets.

2)      Continuation (momentum) – The trend is your friend until the very end. Continuation trading capitalizes on the current trend of a stock or market. You buy whiles stocks remain in an uptrend. Sell when they remain in a downtrend.

  • Indicators: Moving averages, MACD, stochastics, and other lagging indicators likely continuations. Flag patterns and wedges play an important part.
  • Pros: You can identify continuation patterns easily and achieve high win rates.
  • Cons: Continuation setups don’t have well-defined stops. Losses also tend to be much greater than wins.

3)      Consolidation – Some stocks and markets move sideways for long periods. Consolidation trading works to take advantage of channels created in price action.

  • Indicators: Oscillators, trendlines, Average True Range, Bollinger Bands all identify range-bound stocks. Patterns like flags, wedges, and triangles key us in.
  • Pros: Consolidations are very easy to identify and trade with clear risks and rewards.
  • Cons: By the time you find a consolidation, you’re often near the end of its lifespan.

4)      Breakout – Breakout setups look for stocks to expand higher or lower out of consolidation areas. Trading breakouts seeks stocks before they expand out of consolidations. They also will look for breakouts and then retests of the consolidation areas for entries.

  • Indicators: Breaks of Bollinger Bands, Average True Range, support and resistance levels, volume, along with moving average crossovers help identify breakouts.
  • Pros: It’s easy to identify consolidation and when the stock appears to be breaking out.
  • Cons: Many traders see “false” breakouts, which get them buying into breaks higher. The stock then turns around and heads lower.


Trade setups that work during slow markets won’t do well if the S&P gaps down 500 points. Setups that play on reversals fail in trending markets. For the setups to be effective, there must be context.

Context looks at the broader picture beyond the specifics of the trade setup. This includes:

  • Higher time frames – Imagine you trade the 15-minute time frame. A higher time frame like the 60-minute or daily could show you a different angle. Don’t trade a setup on the 15-minute chart for a move higher when it will run into resistance on the 60-minute chart.
  • Other markets – Most equity markets and indices tend to move together. You won’t see many days where the S&P 500 moves higher without the Dow Jones Industrial Average. Correlation doesn’t always exist. But you should be aware of the relationship between bonds and stocks along with others.
  • Known events – Events such as earnings, data releases, or geopolitical events can drive markets. Look no further than the Brexit vote to see how markets rolled over during the night.
  • When you’re trading – Volume and trading come in heaviest at the open and the close of the session. Fridays tend to have lighter volumes. The winter holiday season tends to see low volume. Summer driving impacts on the gasoline markets, while frigid winters drive up heating oil.
  • Market structure – Market structure looks at support and resistance. You review your setup relative to swing/pivot points, retracement levels, and consolidation points. This keeps you from trading a breakout higher into a resistance level.

Trade Management

Remember the last time you entered a trade, and it turned against you? You prayed to the trading gods to get you back to break-even. Never again would you do something so dumb. Eventually, you sold at a loss. And then you did the same thing again a month later.

Why do we all fall into the same pattern? Lack of trade management.

Trade management means you know your trade before you enter. Every trade you know your entry and your exit. Depending on the types of setups you choose and your style, you may have specific prices. Other traders use percentages. Combinations of both work best for some traders who trade in different markets and different time frames.

Above all else, you must manage your capital. Know how much you plan to risk, what you could gain or lose. Look at the impact on your overall portfolio. A trade may be a great setup. But you don’t want to risk 50% of everything you own in one go.

Lastly, more advanced traders know how to adjust their trades. Options traders frequently adjust their positions based on changing probabilities. Most of us are better served by simply sticking to the basics.

Final Thoughts

Despite the complexity, all trading boils down to these three components. Most newer traders fail to consider one of the three. You’ll commonly see traders forget to manage their capital and overleverage their traders. Others fail to win consistently because they fail to consider their setups in a broader context. And some just simply click buttons hoping for a win.

If you’re new to trading, try this simple strategy. Write down each of these three components before you make a trade. If you can’t write all of them, avoid the trade. Once you have a book of them, look at all of them together. See if you sense any patterns or tendencies. You may find that some of what you wrote down at the time doesn’t make much sense later.

About the Author

Trading and investing in markets is second nature to some, but a mystery to others. The goal is to provide a forum where everyday people aspiring to be part time or full time traders will learn how view markets differently and profit beyond their wildest dreams.

David Frost