The differences between swing trading and buy-and-hold investing

If you’re a buy-and-hold investor in the mold of Warren Buffett, you care little for price swings. Over the long term, equity indexes have tended to rise across countries. Therefore, you prefer to buy quality businesses at discounts to their intrinsic value (also known as their true worth). You pore over financial statements and read the notes to the financial statements. You read through earnings call transcripts (the management presentations given after quarterly earnings results). Short-term price movements are merely opportunities to pick up securities (or exit them) at prices not reflective of their true value. In fact, buy-and-hold investors tend to have a portfolio turnover rate (the rate at which their entire portfolio is bought and sold in a year) below 25 percent — meaning they turn over their portfolio once very four years.

Buy-and-hold investing is an admirable practice, and many investors should follow this approach, because it’s not as time-intensive as swing trading and not as difficult (in my opinion). But if you have the work ethic, discipline, and interest in swing trading, you can take advantage of its opportunities to achieve the following:

• Generate an income stream: Buy-and-hold investors are generally concerned with wealth preservation and growth. They don’t invest for current income because they sometimes have to wait a long time for an idea to prove correct. Swing trading, on the other hand, can lead to current income.
• Time your buys and sells and hold a basket of positions to diversify your risk: The majority of people aren’t interested in closely following their finances and are best served by investing in a basket of domestic and international mutual funds covering stocks, commodities, and other asset classes. Swing traders can hold a few securities across asset classes or sectors and generate higher profits than those who invest passively.
• Achieve lower drawdowns than buy-and-hold investing: Sometimes markets become overvalued. Just because a market is expensive doesn’t mean it will tank. Markets often go from being overvalued to even more overvalued. This inevitably sets the stage for a major market crash (think 2000 or 2008). During market crashes, buy-and-hold investors can experience drawdowns of 50 percent or more, meaning a decline in portfolio value from peak to trough. Swing traders, on the other hand, are only in the market when there is opportunity. If the trend is down, swing traders can sit on the sidelines with their cash in tact until sunny days return.

The differences between swing trading and day trading

Opposite the buy-and-hold investor on the trading continuum is the day trader. Day traders rarely hold positions overnight. Doing so exposes them to the risk of a gap up or down in a security’s price the following day that could wipe out a large part of their account. Instead, they monitor price movements on a minute-by-minute basis and time entries and exits that span hours.

Day traders have the advantage of riding security price movements that can be quite volatile. This requires time-intensive devotion on their part. Near-term price movements can be driven by a major seller or buyer in the market and not by a company’s fundamentals. Hence, day traders concern themselves with investor psychology and news flow more than they do with fundamental data. They’re tracking the noise of the market — they want to know whether the noise is getting louder or quieter.

But it’s not all cake and tea for day traders. They trade so often they rack up major commission charges, which makes it that much more difficult to beat the overall market. A $5,000 profit generated from hundreds of trades may net a day trader a significantly reduced amount after commissions and taxes are taken out. This doesn’t include additional costs the day trader must sustain to support his or her activities.

Swing traders also face stiff commissions (versus the buy-and-hold investor), but nothing as severe as the day trader. Because price movements span several days to several weeks, a company’s fundamentals can come into play to a larger degree than they do for the day trader (day-to-day movements are due less to fundamentals and more to short-term supply and demand of shares). Also, the swing trader can generate higher potential profits on single trades because the holding period is longer than the day trader’s holding period.

Swing trading as your primary source of income

If you intend to swing trade as your primary means of generating income, be prepared to spend several months — if not years — gaining experience before you’re able to give up your job and trade from home full time. Swing traders who trade full time devote several hours a day to trading. They research possible trades before, during, and after market hours. And they handle pressure well.

Many traders find that they can’t handle the stress of trading full time. After all, if swing trading is your main source of income, you face a lot of pressure to generate consistent profits. And you may be more tempted to gamble if you encounter a string of losses. What many traders fail to realize is that the correct response to a series of losses isn’t more trading but less trading. Take a step back and evaluate the situation.

Swing trading for a living isn’t difficult in the sense that to excel at it requires some kind of amazing IQ level or insane work ethic. Rather, it requires an incredible amount of self-restraint, discipline, and calm. A swing trader who trades for income must always be unemotional. When things don’t work out, he or she doesn’t try to get even but moves on to another opportunity.

So don’t quit your day job just because you generate impressive profits for a few months. The name of this game is to always have enough capital to come back and trade again. If you plan on living off of $5,000 per month, for example, you can’t expect to generate that kind of profit on $30,000 of capital. That would require a monthly gain of 16.67 percent! Some of the best all-time traders in the world topped out at returns of 20 to 25 percent annually over 20 or 30 years.

Swing trading to supplement income or improve investment returns

This category likely applies to the lion’s share of swing traders. Swing trading with an eye on earning additional income or improving the returns on your portfolio is less stressful than swing trading for a living. You still have something to fall back on if you make a mistake, and you can swing trade while holding down a full-time job.

Part-time swing traders often do their analysis when they get home from work and then implement trades the following day. Even though they may not be able to watch the market all the time, they can enter stop-loss orders to protect their capital. (They really must enter stop-loss orders to avoid the risk of a major decline wiping out a large portion of their capital.)

If you want to eventually swing trade full time, you should go through this phase first. Over time, you’ll be able to determine how well you’ve done. And if you follow the other recommendations in this book (like keeping a trading journal, which I cover in Chapter 3), you’ll learn from your mistakes and improve your techniques.

Swing trading part time is suitable for those individuals who meet the following criteria:

• Have a full-time job
• Can devote a few hours a week to analyzing markets and securities
• Have a passion for financial markets and short-term trading
• Have the discipline to consistently place stop-loss orders
• Are achieving subpar returns in their current investment portfolios from a financial advisor or third party
• Don’t gamble with their own money and are unlikely to fall prey to doubling down or taking major risks

If you fit these criteria, then part-time swing trading may be for you. When you first start out, I recommend swing trading with just a small portion of your portfolio so any early mistakes don’t prove too costly. Although paper trading can be beneficial, it can’t compare to the emotions you’ll be battling as a swing trader when you put your own money on the line.

Swing trading just for fun

Some swing traders get a rush from buying and selling securities, sometimes profiting and sometimes losing. Their motivation isn’t to provide or supplement current income. Rather, these swing traders do it for the excitement that comes from watching positions they buy and sell move up and down. Of course, this can lead to significant losses if they abandon the rules designed to protect their capital — rules that I outline throughout this book (specifically in Chapter 10).

If you want to swing trade solely for fun, my advice is: don’t. I recommend that you get your kicks at a bowling alley or basketball court. The danger of trading for fun is that you’re using real money with real consequences. You may begin to risk more of your capital to satisfy your need for excitement. If you lose, you may take extreme action to prove yourself right in the end, like putting all your money into one or two securities. By then you’re really in the realm of gambling.

If you insist on trading for fun, at least restrict yourself to a small amount of your assets and never touch your retirement nest egg. Remember that you’re competing with traders who are motivated by profit, not just excitement. That gives them an advantage over someone who just enjoys the game.

The “what”: Determining which securities you’ll trade

Many investment securities are in the market: stocks (also known as public equities), fixed income instruments, funds (open or closed end), options, and futures.

This book is geared for swing trading stocks. The following is a description of the three most common instruments I recommend you trade:

• Public equity (stock): A public equity or stock is simply a slice of a ownership of a company with shares traded on an exchange. All companies are either public or private. Private companies can’t be easily invested into whereas public companies can be purchased through a brokerage account. Swing traders often trade stocks exclusively because of the variety, ease, and familiarity of trading corporate stocks. With the Internet you can easily access information on most any publicly traded stock listed in the world (but keep in mind that some countries’ financial data may be in the local language and not in English). Most stocks listed in the United States trade every day, but stocks in foreign markets may have less liquidity than U.S. listed companies (depending on the size of the company and the market).

• Exchange traded funds (ETFs): ETFs are pooled investments. The most common ETFs mirror the movement of an index (such as QQQ, a popular ETF that tracks the Nasdaq 100 Index, an index of the largest technology and consumer sector companies) or a subsector of an index. If you want to ride a coming tech bounce, you may be better served trading a technology ETF than choosing a particular technology company that may or may not follow the overall tech sector. That’s because if you’re right on the move, you’ll profit from a diversified technology ETF. However, a single technology security may buck the trend. ETFs also offer you the ability to profit from international indexes and commodities.

  Stocks and ETFs let you gain access to international markets and other asset classes as easily as buying an item on Amazon. For example, you can gain exposure to the commodity gold by trading an ETF with underlying assets in gold bullion. Or you can gain access to emerging market stocks — stocks of companies listed in India, Brazil, China, and so on — by buying an ETF listed in the United States.

• American Depository Receipts (ADRs): ADRs have become increasingly important in today’s globalized world. Simply put, an ADR allows U.S. investors to buy shares of foreign companies. ADRs are quoted in U.S. dollars and pay dividends in U.S. dollars. Trading ADRs is much more cost efficient than setting up accounts in several foreign countries, converting your dollars into foreign currencies, and so on. And because the economic growth of emerging nations is outstripping the growth of developed countries, ADRs can offer strong profit opportunities. ADRs of companies based in emerging markets (like Brazil or China) are sometimes highly leveraged to a particular commodity, making ADRs one way to profit from commodity price strength.

I recommend you stick to stocks, ETFs, and ADRs for many reasons. Public equities have the following advantages over other investment vehicles like currencies, fixed income securities, and commodities:

• Growth: Over long periods of time, public equities/stocks (for example, ownership in a company publicly traded) have generated higher returns than all liquid asset classes. That’s because stocks give you the opportunity to own a slice of a company that is engaging in growing its earnings over time. Currencies, commodities, and fixed income securities haven’t generated as high returns as public equities over the long term.

• Liquidity: Liquidity refers to how easily you can convert an asset into cash. For example, if you own shares of Coca Cola, you could convert those shares into cash in a few seconds. However, it would take weeks if not months to convert your home into cash.

  Stocks tend to be more liquid than other investments (such as fixed income instruments or options). Currencies are more liquid than stocks but offer less upside, meaning they offer lower returns than stocks over the long term.

• Reasonable downside: Stocks offer competitive returns even without the use of leverage or debt. The most one can lose in any stock is 100 percent (assuming no leverage), but swing traders are likely to exit after a 5 or 10 percent decline in shares if the trade goes against them. Other securities can quickly lose value or expire worthless (such as options). Traders of futures contracts (which can be on commodities or stock indexes) can often begin by putting down as little as 2.5 percent of the value of the contract traded, implying leverage of 40 to 1. A strong move in the wrong direction could easily wipe away 100 percent of your investment.

Many of the other types of securities are illiquid — meaning converting these securities into cash can take longer or be more costly when compared to stocks — and they’re not suitable for swing trading or are too risky to reliably trade day to day (such as options).

More “what”: Trading stocks consistent with your values

You may want to restrict the universe of stocks you trade because of your personal or religious beliefs. Socially responsible investing (SRI) refers to investing in companies that have a positive impact on society. For example, you may avoid investment in companies engaged in practices harmful to people (think companies selling tobacco or alcohol), the environment (think coal), or society (think companies using child labor).

For example, some members of the Catholic tradition (as outlined by the United States Conference of Catholic Bishops) and the Islamic tradition (referred to as Shariah compliant investing) use religious-based investing. Both Catholic and Shariah compliant investment themes include areas such as protecting human life (no abortion), protecting human dignity (prohibiting discrimination, pornography, and so on), and avoiding investment in arms production. Shariah compliant investors also avoid investing in companies engaging in interest-based activities (banks), which can be used to exploit the poor.

Investment restrictions can also be secular in nature. Environmental, social, and governance (ESG) investing has become wildly popular in Europe and is growing in acceptance in the United States and other parts of the world by government and corporate investors. Here is what the ESG considerations represent:

• The environmental consideration of ESG avoids investing in companies contributing to climate change whereas promoting investment in companies operating in the clean tech or sustainable energy sectors.
• The social aspect of ESG investing looks at a company’s policies regarding diversity in the workforce and human rights.
• The governance aspect of ESG investing promotes investment in companies with fair executive and employee compensation policies as well as independent boards that offer proper oversight of management.

If socially responsible investing suits your fancy, you can find more about it at the following websites:

• For a list of socially responsible ETFs: www.etf.com/channels/socially-responsible
• For ethical screening of stocks: www.idealratings.com/
• For the ESG restriction list of the Norwegian Sovereign Wealth Fund: www.nbim.no/en/responsibility/exclusion-of-companies/

The “where”: Deciding where you’ll trade

Where you trade depends a great deal on what you trade. The more trading venues, the wider your investment universe and the more opportunities for profits.

The most popular equity trading venues in the United States are the New York Stock Exchange (NYSE), Nasdaq, and NYSE American. These venues list and trade companies based in the United States and abroad (they also list other investment vehicles, such as ETFs, that enable you to profit from movements in prices of commodities and other asset classes). The Nasdaq was the first electronic stock market and has established itself as the home of the largest technology companies in the world (such as Apple, Alphabet, the parent of Google, and Amazon).

Not all stocks trade on these markets. Recently, electronic communication networks (ECNs) have emerged as an efficient way to match buy and sell orders. ECNs connect individual traders with major brokerage firms. You sometimes can get a better price by submitting orders to an ECN instead of a broker. The easiest way to access ECNs is by subscribing to a broker who provides direct access trading.

But swing traders can buy and sell other securities on other markets. For example, many brokers now offer you access to international stocks via London, Hong Kong, Tokyo, Singapore, and so on. These other markets may be more difficult trade given their trading hours, but they offer a rich set of opportunities. For example, the U.S. equity markets may be in a major decline, for example, whereas Hong Kong stocks are raging higher. Therefore, being able to trade international markets offers you an advantage over the swing trader only focused on U.S. equities.

If your broker doesn’t offer access to international markets (and you’re unwilling to switch your business to one who does), you can also access a limited set of international public equities traded in the United States via ADRs (refer to the earlier section, “The “what”: Determining which securities you’ll trade”) or ETFs.

If you want to trade commodities, currencies, or other investment vehicles, you need to trade via firms authorized to transact in those markets. I don’t recommend you swing trade those securities.

The “when” and the “how”: Choosing your trading style and strategy

Whether you enter orders during or after market hours affects your entry and exit strategies.

• Part-time swing traders enter orders when markets are closed and rely on limit and stop losses to execute this strategy.
• Full-time traders, on the other hand, can execute their entries and exits during the day and incorporate intraday price action into their timing of trades. They also find more trading opportunities because they have more time to devote to swing trading.

How you trade refers to your various trading strategies, which I outline in this section.