Reader Max asks us this question:

What setups do you suggest a novice trader should learn? I have been trading breakout trades quite a lot but many of them seem to fail. What setups do you teach your new classes of traders?
Thanks for your advice.

Thanks for the question, Max. Sadly, there is no easy answer to this question, but I can share a couple ideas to think about.

First of all, I would encourage you to simplify and consider all your setups in broad categories. This may be a:

• Trend continuation trades: pullbacks, flags, wedges, pennants and other types of consolidations in existing trends. May also include the first consolidation after a breakout or potential change of trend.
• Trend termination trades: the name of this category is not an accident; it is not a “trend reversal” trade. All kinds of end of trend and fade patterns on different timeframes fall into this category.
• Support/resistance holding: probably the prototypical model for this category is the classic “range trade” or “box trade”.
• Support/resistance breaking: here are your classical breakout trades.

It is pretty hard to think of a trade that doesn’t fit into one of these categories, though some trades may overlap or borrow from each of these categories. For instance, if you are buying support in a consolidation below 52-week highs, anticipating a breakout to new highs, how do you categorize that trade? If the trader is skilled in making all of these types of trades, the answer might be that it doesn’t matter. You will also see many cases where a trade setup might combine these categories on different time frames. For instance, one trade that works well for me is trading lower timeframe breakouts in the direction of a higher timeframe flag. (Imagine a five-minute bull flag and then a held offer on the tape or a one-minute chart. I am going to be paying through that breakout, hoping that the very short-term momentum from that breakout can set off an avalanche into the higher time frame structure. This is not an incredibly high probability play (meaning it doesn’t work a lot of times), but it doesn’t matter because you have a great risk/reward profile in the trade.)

One more thing that is important for new traders is to simplify. You do not need three moving averages, and RSI, and MACD, Fibonacci lines, Elliot waves and trendlines. Also, make sure you understand every tool you do decide to use. This is extremely important. Before you decide to use that indicator, make sure you really are better off with it than without it.  (How do you answer that? I addressed that question in some of my previous posts here.)

In the beginning, you want to create an environment where you have time to consider the details of your trade setup, can manage the risk, and, most importantly, can focus on being extremely consistent (there’s that word again). Personally, I have always thought that with-trend (trend continuation) trades are a good place to start because, technically, few things are as important as knowing how to harness the power of a trend. As soon as possible, you probably want to add another trade setup, and trend termination trades are ideal. I spent a lot of my early trading trying to do only one trade setup, but my mentor pointed out to me that “when the only tool you have is a hammer, every problem looks like a nail.” What she meant was that I was trying to apply trend continuation trades even in cases where it wasn’t really appropriate.

As soon as you can, I would also suggest adding a countertrend trade. It is far too common to see traders do silly things like a buy a stock because it’s down X%, or short a stock because it “can’t go further” or it “shouldn’t be up this much.” That is ridiculous. There is a correct way to fade trends, so you want to learn to find the cues that suggest a trend might be ending. Obviously, even if you decided to only trade with trend, having this knowledge can help you a lot.

My personal bias is that I am not a big fan of buying support or selling resistance. I think the trades where it works are too rare over a large sample size and it’s difficult to manage expectations. Same with breakouts for a new trader. There’s tremendous potential here, but many variations of these trades as well as the increased volatility means you are going to take some larger rips than you probably wish while you’re learning. It is very important that the trade setup feel right and match your personality, so different people will have different opinions on this subject.

Lastly, be extremely consistent with both your timeframe and market selection. If you want to trade the tape trade the tape until you have mastered it.  Sixty-minute charts are also fine, but don’t cross back and forth. There will be less risk but more noise on smaller timeframes, so, like everything else, it’s a tradeoff. If you focus on stocks over $100, get some consistency there before you go into cheaper stocks with large size. There is a real difference between the way something like JPM or GE trades (usually) compared to FFIV, GMCR, or CREE. Again, the market selection must fit your personality and risk tolerance while you’re learning.

Hope this helps, Max. If I had to give you a simple answer, I would say start either with with-trend or end-of-trend trades, but spend a lot of time making sure you have a solid setup and trade parameters before you just start executing. Good luck!