Chapter 15

Ten (Plus One) Deadly Mistakes of Swing Trading

IN THIS CHAPTER

Bullet Sticking to your plan to avoid unnecessary pain

Bullet Making sure you have enough money to start investing

Bullet Avoiding keeping open positions while traveling

To excel in swing trading, you must not only follow the rules but also avoid harming yourself. After all, just because you speed to work every morning without getting caught doesn’t mean you’ll get away with it tomorrow. The same principle applies to swing trading: Committing one or more of the mistakes in this chapter won’t necessarily bring about immediate punishment (and by that, I mean loss of account value). But you’ll eventually be called to account for repeated infractions.

Violating Your Trading Plan

If you can’t stick to your trading plan, you’re unlikely to make it as a professional swing trader. Your trading plan is your strategy. It governs how you trade, when you trade, and how you exit. Your trading plan should impose certain restrictions, such as how much you allocate to a single position or how you respond to losses. Those restrictions are in place to protect your capital, because the markets often lull people into a sense of confidence — only to pull the rug from underneath them when they start to cut corners.

Warning Violating your trading plan is a little like defying authority. But unlike in a traditional job setting, where defiance involves an employee and employer, trading plan violations are acts of defiance against yourself. You’re literally hurting yourself, whether you know it or not.

If you violate your trading plan routinely, even in small matters, you may violate your plan in bigger areas — such as position sizing or diversification standards. In other words, you start to think you’re above the law and can make decisions as you see fit. Who needs a trading plan when you’re numero uno in the market? This negligence represents a mass abandonment of time-tested, necessary rules.

Of course, you can always revise trading plans if you want. Just do it outside the market hours and for a good reason, like making changes only after reviewing and assessing your trading journal entries. Random acts of violation (sounds like a criminal term, I know) make deciphering the source of strengths or weaknesses in your plan rather difficult.

Starting with Too Little Capital

Swing trading requires a minimum level of capital to execute efficiently for the following reasons:

  • Diversification: Spreading a small amount of capital, say $5,000, into ten trades is tough. Some stock prices are $200 or $300 per share. Therefore, you need a larger account size in order to properly diversify.
  • Cost: A small capital base requires gigantic returns just to cover brokerage commissions and other fees.
  • Realistic target return: Good professional swing traders can reasonably expect to make an average of 10 to 20 percent per year. Starting with a small account value may encourage you to take bigger risks in order to generate a certain absolute dollar gain (for example, a $500 gain on a $5,000 portfolio requires a 10 percent return).

So how much capital do you need to get started in swing trading? Here are some guidelines to fit the different types of swing traders:

  • Trading for fun: If you enjoy swing trading as a hobby, then you can swing trade a portion of your existing assets. The restrictions outlined earlier don’t apply if the majority of your assets are being invested wisely (that is, they’re diversified and professionally managed). In this case, you can trade 10 to 20 percent of your total assets as long as your swing trading portfolio is greater than or equal to $15,000 (to cover costs like commissions or research services).
  • Trading for retirement: If you’re swing trading your retirement account while still working full-time, you’re not depending on the trades to provide you with current income. So you can probably begin with $25,000 and hold 8 to 12 positions.
  • Trading for a living: If swing trading is your full-time job, then you need to start with a reasonable size nest egg to live off of. A professional swing trader can reasonably expect to make 10 to 20 percent per year, so if you need to spend $5,000 per month on living expenses, your account value needs to be between $300,000 and $600,000. (Achieving 10 percent on $600,000 equals $60,000 per year, or $5,000 per month. But if you’re really good, you may achieve a return of 20 percent per year on $300,000 — equal to $60,000 per year, or $5,000 per month.)

Gambling on Earnings Dates

Swing trading a stock one or two weeks before an earnings announcement is a form of gambling. My old mentor, Ian Woodward, likens trading before earnings to driving a car without your hands on the steering wheel. I’ve never tried driving that way because I want to live to see tomorrow.

Remember Earnings dates are, for the most part, unknown events. Unless you have some predictive ability I lack, you can’t know with certainty whether a company will miss its earnings mark or profit handsomely. Even if you knew the company would beat its expectations, nothing guarantees the stock will perform as you expect it to perform. You’re better off avoiding trading stocks before their earnings dates, even in the case of large cap stocks.

Tip The best time to get into a trade is often on the day of or after the earnings announcement.

Speculating on Penny Stocks

When I first started trading, I immediately gravitated toward penny stocks, which I define as all U.S. stocks that trade below $5, even though other market commentators classify them as stocks trading below $1 per share. Back in 1994, I said to myself, “I can make 20 or 30 percent if this penny stock moves by 5 cents!”

Warning Unfortunately, penny stocks are the fool’s gold in the market. They look tempting but don’t lead to riches because they exhibit low liquidity and are volatile. They’re more susceptible to rumors or tweets, which can spike shares up or down. (Note: An exception to this rule is international securities that may routinely trade for a small amount of money. For example, many Australian shares trade for less than 5 Australian dollars per share without the negative stigma that accompanies U.S. securities trading below $5.)

Warning Penny stocks aren’t necessarily companies you’ve never heard of, so don’t be lulled into a false sense of security about a security just because you recognize its name. Otherwise you’re setting yourself up for failure. Don’t believe me? Penny stocks have included such well-known companies as Sears Corporation, JC Penney, and Sirius XM Holdings.

Changing Your Trading Destination Midflight

Imagine the problems that may arise if pilots routinely changed their minds on their intended destination midflight. Airports wouldn’t be able to anticipate which planes may be landing today, passengers would get upset, and regulators would have a nightmare ensuring plane safety.

Swing traders sometimes commit the mistake of changing trading destinations midflight, which means changing the reason you trade a security after you’ve initiated the trade. More often than not, a midflight change occurs because the trade hasn’t gone your way. And rather than take a loss, you prefer to sock that puppy into a stocking, because you know the market’s totally off in its assessment of the company’s prospects. The problem with this approach is that it keeps a poor-performing security in a portfolio when it should be sold. That security’s poor performance can become worse and lead to even larger losses.

Remember Stay focused on growing your portfolio over time and don’t change the reasoning behind a trade just because it doesn’t go your way. Instead, correct the problem and move on.

Doubling Down

By doubling down, I don’t mean trying to win big at blackjack. In the swing trading world, doubling down means doubling your investment in a trade when the trade goes against you. This strategy may sound appealing, but it’s fraught with danger. So what tempts swing traders to consider doubling down? Because if you trade that security again and put even more money into it, a slight move up could lead to untold profits!

For instance, if you buy $10,000 worth of Apple Inc. for $100 per share, and the stock immediately falls to $90, you’re facing a $1,000 loss. That’s not pretty. But if you double down and buy another $10,000 worth of shares of Apple at $90, you can gain back that $1,000 loss to break even when shares rise to $95. By increasing your investment to the losing trade, you lower the price the stock must rise to in order for you to gain back your prior losses. But doing so isn’t worth the risk.

Warning Doubling down is a double-edged sword — if shares march down more, your losses compound because you’ve now exposed yourself to double your initial investment. Never send good money after bad. If you have a loss on a trade, then your original trade idea was wrong. Adding more money to the trade doesn’t make you right (remember, though, that your trading strategy isn’t necessarily to blame, because losses are a natural part of doing business).

My friends in the investment community may pipe up right about now to exclaim that doubling down can be an effective investment strategy for some people. In fact, retirement professionals often advocate a version of doubling down. Investors who have long-term time horizons don’t care about short-term losses the way swing traders do, though. Moreover, there is a fine difference between doubling down on a stock versus doubling down on a diversified fund (which may make sense in a retirement portfolio).

As a swing trader, you must follow the beat of a different drummer, because you’re principally concerned with short-term gains. Consequently, you care about short-term losses. You don’t have the luxury of waiting three years to find out whether you’re right. If you aren’t right in the first few days, then you probably need to exit and move on to another trade.

The opposite — adding to a winning position — is okay as long as you obey your risk management strategy.

Keeping Open Positions While You Travel

Time for a vacation! Or perhaps a trip for work? So how should you handle your open swing trading positions? Perhaps you think you’re crafty and can check on your stocks while waiting in line at an amusement park or in between servings at Grandma’s.

Unfortunately, trying to juggle swing trading while you’re traveling is a recipe for disaster. You simply won’t have the concentration or time to properly vet decisions. You may be up one moment and a major news announcement sends your portfolio off the skids. And because you’re traveling, you won’t have access to the normal tools you use to review the positions and figure out what’s going on and whether to exit.

Remember The one exception to this rule (and it’s best not to rely on this exception) is when you implement tight stop-loss orders with your broker before traveling. These aren’t soft stop-loss orders that you’ve recorded in your smartphone. Rather, they’re orders you entered with your broker that your broker will execute if the shares fall below a certain level. If you have tight stop-loss orders on all open positions, then you can keep them open while you travel. But I still don’t recommend it.

Thinking You’re Hot Stuff

If you string together several winning trades, you may start to build confidence in your strategy and skills as a swing trader. Good for you! But if your confidence turns into arrogance, you’re going to cut corners and take greater risks. Regardless of how good you think you are, plenty of other traders are out there who may be better informed or better prepared. A humble trader isn’t afraid to admit mistakes. An arrogant trader thinks the market’s wrong and he or she’s right.

One area where I’ve seen the hot-stuff factor exhibited is in a trader’s education. Some traders falsely believe that after you know the tools of the trade, you don’t need to figure out anything else. Yet the markets are a living organism. You need to keep up to speed on the news surrounding them and the books pertaining to trading.

Tip Try setting a goal for yourself to read at least one trading-related book a month, like I do. If you’re constantly taking in new information, you’re less prone to thinking that you’re the be-all, end-all when it comes to trading, and you can avoid the fate of smart traders who are brilliant on an IQ level but not in practice. These folks generate impressive returns for several years only to quit swing trading because they can’t control risk or admit their mistakes.

Concentrating on a Single Sector

According to behavioral scientists, traders and investors sometimes exhibit a familiarity bias, an investor’s tendency to invest in companies he or she knows or feels familiar with. Often employees of publicly traded companies have a significant portion of their retirement assets invested in their employer’s stock. Although they may feel comfortable investing in a company they know a lot about, this bias can be dangerous because it increases the chances that their portfolio won’t be well diversified and that their account will experience more volatility.

Many Enron employees in the 1990s had the majority or the entirety of their retirement assets invested in the energy company’s stock. Had they diversified their holdings to less-familiar parts of the market, the payoff may’ve meant having a nest egg versus having nothing after Enron went bust.

In swing trading, familiarity bias rears its ugly head when you focus on a sector of the market you know a lot about. A swing trader who enjoys information technology, for example, may trade shares of Microsoft, Apple Inc., Hewlett-Packard, Cisco Systems, and so on. Such swing traders may in fact build a portfolio of 10 or 12 different stocks, but they don’t have diversified investments.

Tip Following a top-down approach to swing trading (which I explain in Chapter 8) can also lead to overinvestment in a single sector if you’re not careful. For instance, if energy stocks are doing well, then you may be tempted to hold a whole basket of different energy stocks, thinking your portfolio is diversified. If you buy one stock from each of the top ten industry groups and are 70 percent invested in the energy sector, your risks are high. If energy turns down violently, those positions will all fall together.

Remember You must diversify your portfolio across sectors that are driven by different risk factors. If commodities are outperforming stocks, swing trade companies that benefit from a commodity boom (for example, commodity producers) but don’t only invest in such companies; add in stocks from other strong sectors uncorrelated to commodity prices. Or, if regulations are changing that will positively impact pharmaceutical companies, swing trade drug manufacturers along with sectors uncorrelated with pharmaceuticals. In other words, go where the strength is but always be aware of how exposed you are to a single sector.

Trading Illiquid Securities

Trading illiquid securities can cost you dearly — all in one fell swoop. Illiquid stocks refer to stocks with average daily value traded below $100,000. Of course, if your account value is sufficiently large (say, more than $1 million), then the definition of illiquid stocks would be higher than $100,000 value per day. The key is how quickly you can enter and exit a position; a swing trader should be able to enter in a single day without materially affecting the share price.

Trading illiquid stocks may appeal to you because they can make big gains when a little volume is added to the mix or some event occurs and people rush to buy shares.

But illiquid stocks introduce a new risk factor that you may not be properly compensated for. A swing trader isn’t in an investment for years. Investors with long-term horizons can pick up the illiquidity premium or additional gain awarded to some illiquid shares because they can afford to be patient month to month or quarter to quarter.

Swing traders need the flexibility to quickly enter and exit a security because they’re capitalizing on events expected to play out over a few days or weeks at most. They aren’t focused on being an investor or a long-term shareholder in a company. Long-term investors can afford to invest in illiquid securities. Swing traders can’t.

Overtrading Stocks

You may find it curious that I list overtrading as a mistake in a book about swing trading. How can a swing trader possibly overtrade? Isn’t that the whole name of the game in swing trading? Well, yes and no.

Remember Swing trading is principally defined by the short-term nature of the price swings it attempts to capture. Obviously, those price swings require more trading than the buy-and-hold investment strategy, but you should still trade as few times as possible in order to achieve your objective. Why?

  • The more often you trade, the more work you need to do.
  • Trading entails costs, and costs hurt returns.
  • This extra work increases administrative costs (both money- and time-based) involved with keeping track of the trades, entering them into a journal, and reviewing them at a future date.

Swing trading is supposed to fit in the happy medium between the day trader who slaves away over miniscule price movements and the buy-and-hold investor who sits on his or her hands until they become numb. The more often you trade, the more likely you’re simply trading market noise (moves driven by non-fundamental reasons).

Buying and selling often or intraday makes your success as a swing trader that much more difficult — so get in before a major price move and get out after you capture it.

Tip I can’t give you a set number of trades to place per week or per month, but on average, your trade length should last several days to several weeks. If you’re holding positions for shorter amounts of time, you need to examine that part of your trading system. Are losses that force liquidation causing you to trade this way? Or are you becoming impatient and trading in and out because you’re looking for the elusive stock that’ll make a major move the day after you buy it? “Keep it simple” is a saying my tenth-grade math teacher wrote on my notebook in class one day. The same advice applies to swing trading.

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