Why Setups Are Only One Part of a Trading System
A setup is a condition, or a group of conditions, that must be satisfied before an entry is even considered. It is the filter that tells a trader that a market, a company or a price pattern is worth attention. When people describe famous systems, the setup is usually the part they remember, because it is the part that can be written as a checklist. CAN SLIM can be reduced to seven letters, Buffett's approach to a list of criteria, and Ken Roberts' method to a numbered pattern. That visibility creates a common misunderstanding: that the setup is the system. The study notes behind this article make a sharper point. Most traders place the main weight of their attention on the setup portion of their system, yet only around ten percent of a trader's effort should go into selecting and testing setups. The reasoning is structural. Entry involves five steps: system selection, market selection, market direction, the setup itself, and timing. The first four of those steps are also forms of setups, which means the setup concept is broader than most people assume, not narrower. Just as important is what a setup does not contain. A set of entry conditions says nothing about where a protective stop belongs, how a position will be exited, or how large the position should be. Those three elements, especially position sizing, are usually described as the most critical parts of a system, and they sit outside the checklist. CAN SLIM, for example, tells a trader what kind of stock to look for; it does not tell the trader how much to buy or when to leave. When studying any well-known model, it helps to separate the setup rules from the risk rules, because the two are often published in different places.
William O'Neil's CAN SLIM Trend-Following Model
CAN SLIM is an acronym in which each letter represents an entry criterion. C stands for current quarterly earnings per share, with O'Neil's standard being roughly a seventy percent increase over the same quarter of the previous year. A stands for annual earnings per share: the record should show an annual compound growth rate of about twenty-four percent or better over the past five years. N stands for something new, which can be a new product or service, a change in management, or a change in the industry. The same letter also covers a new price high for the stock, making N effectively two criteria, with the price high acting as the entry trigger rather than a filter. S refers to shares outstanding. O'Neil's research on the best-performing stocks found an average capitalization of under twelve million shares, with a median of only about 4.8 million, so the criterion calls for a small float, generally under twenty-five million shares. L stands for leader, and it rests on relative strength. Practitioners of relative strength typically rank all stocks by price change over the past twelve months and consider the top seventy-five to eighty percent; some weight the most recent thirty days more heavily. O'Neil's version is comparable, selecting stocks ranked above roughly eighty percent. I stands for institutional sponsorship: leadership often requires some institutional participation, but heavy sponsorship is undesirable, because any problem can trigger large-scale selling, and by the time every institution has recognized an issue it may be too late to anticipate the move. M covers the overall market. Since seventy-five percent or more of stocks tend to move with the general averages, O'Neil treats a positive market condition as a required criterion before buying. The notes add an important caveat: many people assume O'Neil's trading system consists only of these criteria. The mnemonic is entirely made of setup standards. Beyond knowing that N includes a new price high, it says little about the actual entry, nothing about protective stops, nothing about exiting, and nothing about position sizing.
