Longwood Currency Trading





Current Picture Hi, I'm Peter Rose, Founder of Longwood Currency Trading, and welcome to LCT Blog Post 07/25/20 — How to Evaluate a FOREX Trade Entry Setup.

In this post I'll be discussing a methodology for evaluating a FOREX trade entry setup.

Bear in mind that a methodology sets out principles, whereas a system puts forth a specific plan.

I try not to talk about systems, or use example charts because a system comes about as a result of a methodology, a lot like a plant comes about as a process of correct planting. So, if you understand methodology, then the system part is simple.

As such, if I brought up a lot of specific chart formations showing such a system, endless arguments would ensue as to 'cherry picking' sections of price action that do exactly what the system says it should do.

Those sorts of criticisms usually come from uneducated and unsuccessful traders who just want to show others how smart they are by pointing out how 'stupid' the person is going through the example.

If you're such a person, go find someone else to complain about....

Before continuing, I might caution you that this is probably not going to be a casual read.

As a scientist and engineer as well as an investor, I approach problem solution using highly structured processes that for someone not familiar with that sort of presentation may find it off-putting.

If that's the case, then I apologize. However, systems design and development are such an integral part of how I've lived my life that I bring these skills into play when I discuss any topic.

For example, I've written a couple of unpublished financial thriller novels that I enjoyed doing, and those who have read them think they're quite good. They remain unpublished simply because I love the creative writing process, but hate the marketing side. Regardless, every book that I've written (and I've written many books over many topics; yes: all unpublished) was done by following a specific methodology. In fact, each scene was written with a specific plan, or methodology just for that scene.

Thus, what I will be sharing with you in this post is not how to identify a FOREX trade setup, but rather a methodology that wraps around that analysis process. So, it might get a little more involved than most trading educators content is presented.

But that's okay. I don't write entertainment pieces. I write informational articles with the intent of showing how to make the trading process simple. If you're unfamiliar with structured analysis writing, then you might find this stuff a little tough at first to get through.

The design of a car is quite complex, but operating it is as simple as putting some gas in the tank, and turning the car on. So too in trading: the design of the methodology may appear complex, or difficult, but implementing it into real time price action will then be very simple.

Spend a lot of time building a solid methodology so that you can confidently use it over, and over again because it's so simple to implement.

Methodology Fundamentals
A methodology must first identify a few base fundamental elements that define its scope, and its structure:
Base Elements of a Methology
  • What specific issue does the methodology resolve?
  • What is the benefit of reaching the methodology's end goal?
  • What are the boundary conditions of the methodology?
  • What is the methodology's best case solution path?
  • What events could occur that would render the methodology inappropriate?
  • What events could occur that would require alternate methods of solution?

Because I'm a scalper, or day trader, the analysis I provide in this post is directed at solutions for that type of trading. If you're a long term trader, then you would just make the necessary and logical adjustments needed which satisfy those requirements.

Don't get lost in the woods here with the following discussion topics of building this methodology because they only represent what the methodology is, not how to implement each piece.

What specific issue does the methodology resolve?
The 'specific issue' that the methodology resolves is referred to in software engineering as its 'problem domain'.
Definition: Problem Domain

A Problem Domain defines the full scope of the problem to be solved.

You might at first glance think that this is a really stupidly simple question.

It's actually critical to building a methodology that in software engineering is referred to as 'encapsulated'.

Definition: Encapsulated

Encapsulated simply means that all of the parts of the methodology are not only essential, but that they only deal with supporting the solution to the specific problem domain of the methodology.

So, in order to do that, i.e. to solve the problem, you have to very specifically define it, or you'll be doing work outside of the problem domain, which is called 'scope creep'.

Scope creep is like setting out to just fix an issue with your lawn mower's carburetor, and getting side tracked sharpening the blades, and changing out the pull cord. All that other stuff may be important, but they can't be part of the specific problem domain of 'just fix an issue with your lawn mower's carburetor'.

Thus, if you don't get the methodology's specific solution issue precise, the rest of the methodology could (and most probably will) not only contain unneeded tasks, but the entire viability of the intended plan is degraded.

The purpose of this post is to discuss — and only discuss: "a methodology for evaluating a FOREX trade entry setup." This means that this methodology won't deal with any aspect of position management, exit techniques, staging out issues, etc. Nothing. Just how to evaluate a trade entry setup. Period.

Well, you're thinking that is not only just really, really simple, but soooo painfully obvious.

Nope. Without taking the time to clearly identify the problem domain of the task, the only painfully obvious thing will be almost guaranteed losses....

Target Methodology

Define a methodology TES (Trade Entry Setup) for evaluating a FOREX trade entry setup.

Stupid simple, I know....

What is the benefit of reaching the methodology's end goal?
In order to contain the problem domain of what a FOREX trade setup is, you have to have a clear idea of what condition satisfies the solution of that problem domain, what the 'goal' of the methodology is supposed to be.

If you don't 'contain' the problem domain (i.e. encapsulate it), then how do you determine the success of following the methodology that's supposed to solve that problem domain?

TES Methodology Goal

The successful implementation of the TES Methodology will be the establishment of a FOREX trade entry setup which creates a currency pair position resulting in at least a 5 pip profit gain.

Stupid simple, I know....

What are the boundary conditions of the methodology?
Boundary conditions are other problem domain encapsulation determinants.

We already have 2: The setup analysis, and the trade entry itself.

By defining that one of the boundary conditions is setup analysis means that the methodology will not be concerned with position management, for example.

Though the other boundary condition I've defined as the trade entry itself comes contingent with the caveat that the end goal of the methodology is to result in a 5 pip profit target, this does not imply position management to get there.

Because of this, someone who will use this methodology will know that their analysis to provide that 5 pip gain must be contained, i.e. encapsulated, within boundary conditions of the setup, and the actual trade entry event.

That's great because what the methodology is actually stating in these boundary conditions is that risk and profit targets must be determined before the trade is entered.

You getting a better feel now for not only what all this analysis is, but why it's so essential to do it up front?

You do all of this stuff once, and then you can use it over, and over again without needing to complicate what you're trying to do. It's a wonderful thing.

Having said all of that: do we need any other boundary conditions for this problem domain?

Yes, but I'm going to leave that for you to discover on your own.

This post is only about how to go about creating a methodology for FOREX trade entry setup. It's not meant to provide a fully flushed out working methodology.

The reason for that is because going into greater depth than I am here would require me to build out the methodology for my own trading purposes. And that's going to be based on my personality, my needs, my goals, etc.

I've sort of even hinted at that by indicating that the goal of the methodology was to result in at least a 5 pip profit gain from the setup. But your target might be 20 pips, or 200 pips.

If I have a student, we go through this process as it relates to them. Thus, there is a lot more detail that is developed within not only the methodology, but also within the problem domain which the methodology is being built to solve.

This is why a mentor is so critical. A mentor is a guide who... well, guides you through all of this stuff.

Unfortunately, few have the background that I do, and so it's rare that an educational resource will have any idea of what any of this is, much less how to present it, nor understand that they can't do it in a class or seminar of 30....

Look, this stuff isn't that tough! Really!

We've just gone through 3 of the 6 steps I'm going to cover in this post. Go back through just those 3 now, and see how simple it all is.

Sure, at first run through it's complex. And, quite frankly, the summation of all of the steps (and a few more that I am leaving out just to keep this stuff as easy as possible to read through) is quite complex.

You just take it one small, simple step at a time, and figure it out, and determine how each step lays the foundation for the next step which relies on that previous step to glue everything together.

If you need some help or detailed guidance, then get in touch with me. But before you pay me a lot of money, be sure you're at a wall and just can't see how to get to the other side on your own. Oh, I won't charge you for just some tips on where to go with your study; I'm not running a training business.

I'll try to give you whatever guidance I can if that guidance is simple and can really help you figure out what to do next. But if I see that you need more than just some basic information, we can discuss that and figure out what you are comfortable doing.

So, if you'd like a little more info on this stuff, or anything else trading or life related, throw me an email with your full name: weird email addresses with no contact information smell of trolls, and are ignored. If you don't hear back from me within a few days, send me another email with more disclosure so I know you're not a shit head waisting my time.

TES Methodology Boundary Conditions
  • Trade entry setup analysis.
  • Trade entry point.
What is the methodology's best case solution path?
Determining the best case outcome, i.e. the solution path, for a methodology can be made really easily if you're familiar with Project Planning using a PERT Chart.

A PERT Chart is a time based graphical representation of the various possible solution paths of a problem. The acronym PERT stands for: Program Evaluation and Review Technique.

Basic elements of a PERT analysis
  • What is the methodology's PERT Chart equivalent of the Optimistic Time, or 'Happy Path'?
  • What is the methodology's PERT Chart equivalent of the Pessimistic Time, or 'Worst Case Path'?
  • What is the methodology's PERT Chart equivalent of the Most Likely Time, or 'We Hope This Happens Case Path'?

I'm not going to develop a PERT Chart in this post because if you're that interested there are just tons of information for your review 'out there'. Enjoy the learning journey!

Without working up the diagram of those questions, I'd just like to comment on why you'd at least want to consider this stuff when building your trade entry methodology.

The Optimistic Time is the absolutely best time it would take to accomplish a task. Say you're building a project plan to move your office to another city. The Optimistic Time would be that time where no stop lights were encountered for the moving trucks, nobody gets sick, all permits are in place, etc.

The Pessimistic Time is how long the move would take if everything went wrong.

And, the Most Likely Time is sort of the average between those two extremes.

Simple, right? Yup. For an office move. But what about creating the TES Methodology for solving the problem domain of creating a FOREX trade entry setup?

The Optimistic Time wouldn't really be a 'time', but rather a process. Optimistically, when looking for a trade entry you'd only want to trade the open, for example. The Pessimistic Time could be that you're going to have to sit at the screen all day so you don't miss any opportunities. And the Most Likely Time might be that you'll only look for potential trades from 5:00 am to 6:00 am before you have to head off for your job.

You'd do that sort of up-front decision process for every step there is in the identification to the execution of a trade. Which, in turn, requires you to identify all of those individual steps.

What events could occur that would render the methodology inappropriate?
This step becomes part of the overall development of the TES Methodology PERT Chart analysis process. It was broken out as a separate phase of analysis so that if you fell asleep during the discussion of PERT Chart development, you'd at least know that these steps were important in your overall methodology building considerations.

What events could occur that would require alternate methods of solution?
This step becomes part of the overall development of the TES Methodology PERT Chart analysis process. It was broken out as a separate phase of analysis so that if you fell asleep during the discussion of PERT Chart development, you'd at least know that these steps were important in your overall methodology building considerations.

Sample FOREX Trade Entry Setup Methodology
The following is a brief example structure (without PERT Chart analysis) of a possible trade entry setup methodology that touches on the issues covered in this post.
Sample FOREX Trade Entry Setup Methodology

Purpose: Development of a FOREX trade entry setup methodology (TES).

Goal/Benefit: Achieve a successful trade entry such that a minimum of 5 pips is achieved even if the position does not reach the anticipated profit target.

Boundary Conditions: The setup analysis, and the trade entry itself limited to USD/JPY between 05:00 US ET through 06:00 US ET Tuesday, Wednesday, and Thursday.

Best Case Solution Path: 30 pip profit target capturing average of at least 13 pips overall with an 8 pip risk and win to loss ratio of 70%.

Non Trade or Trade Termination Events: Erratic overall price action volatility, NFP, pending country pairs or world event news, adverse physical or mental condition of trader.

Plan Altering Events:

  • Price action shows immediate loss of 5 pips: Exit.
  • Price action fails to make progress within first 1 minute of execution: Exit.
  • **Profit locked at 5 pips, but price action begins to chatter: Exit.
  • **Price reaches profit target but has signs that it could progress: Trail 5 pip hard limit stop.

**Note that the last 2 entries in the Plan Altering Events section appear to be position management rules which would be outside of the scope of the problem domain as discussed earlier.

This could be argued both ways. I include them to show a potential issue that you'd need to decide on your own as to whether such issues are appropriate to the problem domain or not.

I include those 2 issues in my thought process of trade set up because I want to know up-front before I place the trade that there either is, or is not structure to the left of my analysis region that could create such anomalies in probabilistic entry calculation considerations.

Pulling it all together to make sense of the process
Again, all of this might seem not only too time consuming to go through, but complicated.

I agree that it would be — if you had to do it every time you were evaluating a trade entry setup.

But you don't have to do it every time.

You do it once, and then use it over, and over again.

Even better is that if you can keep each one of these methodologies simple then, after using it a few times, it'll just become so natural to you that you won't have to physically refer to it.

By developing structured methodologies such as this has soooo many benefits.

Primary to these benefits is that the collection of your trading methodologies, which are very simple, and totally encapsulated units of thought, automatically form your overall trading plan.

Traders in general really don't understand the importance of having a trading plan mostly because none of the educational references seem to understand how to explain this.

It's a lot like a driving instructor telling a new driving student that they need to have road maps or GPS, and emergency things like flares, gloves, and tools. Just when is the student going to understand the importance of this? Yup. When they're out on some country road with a flat tire in an ice storm at night....

By developing these simple methodologies up front, a trader can totally understand their utility because as they are learning the trading process fluidly from their mentor, they can grasp the significance and utility of that methodology because it directly addresses the issues that they are facing right then.

After developing your own full set of methodologies, you'll have a very, very clear understanding of not only each methodology's importance, but how those methodologies all fit together into a logical trading plan.

Gad, all of this stuff is so stupidly simple that I really laugh at all of the traders out there that moan and grown about how tough trading is, and that folks need to spend thousands of dollars to learn basic mechanics and plumbing in order to learn how to trade.

That's all just useless, and detrimental, advice — at best....

Did you really learn anything from this post?

Probably. But do you really understand how to implement it on your own?

Probably not. And so where's your motivation to actually do it?

Well, I hope what I've provided to you in this post is to look for this type of advice in the books you read, videos you watch, or from those you seek advice from because, unfortunately, it becomes your responsibility to ask these questions if you're not getting the answers you need if you're not getting that advice.

A methodology such as the one I just covered to discuss trade entry setup is basically a set of rules.

Thus, if you find yourself not getting the results from your trading that you had anticipated, you can look to the methodology you developed for that aspect of your trading for the elements that need adjusting.

It makes problem solution so much simpler. Instead of wondering what you're doing wrong, the answer will be right in front of you.

I've written book length analysis documents about this stuff to make it crystal clear in my mind as to how I should approach each aspect of my trading in a logical, and simple manner.

That's why I feel good about what I do — whether the the trade works out or not.

And when I do something really stupid and lose big, then I know exactly what the problem was. I fully understand and accept that the problem was me, and that I can either choose to fix that or ignore it.

When I do something stupid, I have no one and no 'thing' to blame but myself because what I should do is written down in a series of clear, concise, and simple methodologies that constitute my trading plan.


Thanks for taking your time to read this post,
Peter

p.s. For more of my thoughts on trading in the FOREX foreign currency market, check out my YouTube channel for Longwood Currency Trading


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