In trading, it is usually the simplest setups that give consistent success to a trader. A trade setup consisting of simple and obvious rules for entry, exit and stock selection is more powerful than a trade setup built with many and complex rules.

Today’s newsletter is about these simple rules that make up an effective trade setup. We will build a simple trade setup, understand the logic of the various elements of this setup and build a scanner for identifying the trades.

The trade setup

The idea behind this trade setup is simplicity. There will be one indicator for trend, one for momentum, an entry trigger, and understanding of timeframes. Because the Indian equity markets are bullish, we focus on long setups.

Element 1: Exponential Moving Average (EMA)

EMA are one of my favorite trend analysis tools. It is one of the most popular indicators as well. This indicator helps the trader understand the average closing price of an instrument. The use of EMA in the trade setup is simple. If the price is trading above the EMA, it is in an uptrend and if the price is moving below the EMA, it is in a downtrend. The setting can be 21 candles’ closing price. We use 21 period because there are roughly 21 trading days in a month, and we want to trade above the average closing price of at least a month.

Element 2: RSI

RSI stands for Relative Strength Index. RSI is an important component of this set up. The price can be above the moving average but still move slowly. We want the price to be in an uptrend, but we also want speed. We want momentum. Momentum is the rate of change of price. High momentum means the price is moving fast. I have observed that when the price is in an uptrend, the RSI will rarely fall below 40 levels and when the price has to move fast, it will stay above 60 levels. Therefore, for our setup, we want the RSI to be above 60 levels.

Element 3: Timeframe

The rule of timeframe is that the longer the holding period, higher the timeframe of chart and analysis. The logic is that when the decision taken based on the candles will let us predict the next few candles. Therefore, these next few candles will be defined by the timeframe. The following are some of the timeframes with their holding periods:

Monthly timeframe: Holding for a few months
Weekly timeframe: Holding for a few weeks
Daily timeframe: Holding for a few days
75-min timeframe: Holding for a day or two.

Daily timeframe is used in today’s newsletter. Although, this can be subjective.

Element 4: Entry and Exit

The entry can be based on two types of trading: Breakout trading and pull back trading. Breakout trading refers to participating in a trade when the price has breached above the previous high formed by the price. Pull back trading refers to participating in a trade when the price is near an EMA or when the price has breached the previous high and subsequently revisits the breakout level. Entry in both the cases is based on price pattern. But, for breakout traders, the exit will be the low of the most recent low formed by the price and the exit for pull back traders will be low of the participation pattern.

This completes the trade setup. Simple and effective with clear entry and exit. Let us now see how to build a scanner. However, we need to understand that many variations to the setup can be formulated to increate the efficiency of the setup.

Building a scanner

To build a scanner, we will use RZone website developed by Definedge securities.

Go to RZone → System Builder → OHLC charts → Create System Builder.
1. Add Indicator → Single Moving Average → Choose Close price above MA, Average type EMA, Period 21, Candle: 0.
2. Add Indicator → RSI → Above value: 60 at Candle 0
3. Add Pattern → Last Candle bearish at 0
Expression: 1 and 2 and 3
And Save.

To Scan, Go to RZone → Price Scanners → Candlestick Scanners.
Choose the scanning condition, Group, and timeframe and scan.

The trader can save the list and analyze them individually to identify trade opportunities.

The Secret ingredient

We have built a trade setup. But we haven’t discussed one important element: What to trade? Although the scanner pulls out the stocks from the group that meet the conditions of the setup, not all stocks are tradable. We need to choose the socks that will improve the probability of success. This stock selection can be done through reading their Relative strength charts. Relative strength is one of the most useful tools for the selection of stocks that will have more probability of moving in the direction of the trend. Check out the course below to learn how to choose the right stocks to trade using Relative strength