Chapter 1

Swing Trading from A to Z

IN THIS CHAPTER

Bullet Contrasting swing trading with other types of trading

Bullet Deciding how much time you want to devote to swing trading

Bullet Getting strategic by preparing your trading plan

Bullet Avoiding the mistakes that many swing traders make

You can earn a living in this world in many different ways. The most common way is by mastering some skill — such as drugs in the case of pharmacists or coding for web developers — and exchanging your time for money. The more skilled you are, the higher your compensation. The upside of mastering a skill is clear: You’re relatively safe with regard to income. Of course, there are no guarantees. Your skill may become outdated (there aren’t many horse carriage manufacturers operating today), or your job may be shipped overseas. You also have a maximum earning potential given the maximum hours you can work without exhausting yourself.

But there’s another way to make a living. Swing trading offers you the prospect of earning income based not on the hours you put in but on the quality of your trades. The better you are at trading, the higher your potential profits. Swing trading takes advantage of short-term price movements and seeks to earn a healthy return on money over a short time period.

Remember Swing trading is a good fit for a minority of the population. It involves tremendous amounts of responsibility. You must rely on yourself and can’t be reckless or prone to gambling. If you’re not disciplined, you may end up with no income (or worse).

This chapter is an overview to this book and your guide if you’re interested in swing trading.

Understanding What Swing Trading Is (and Isn’t)

Swing trading is the art and science of profiting from securities’ short-term price movements spanning a few days to a few weeks. Swing traders can be individuals or institutions. They’re rarely 100 percent invested in the market at any time. Rather, they wait for low-risk opportunities and attempt to take the lion’s share of a significant move. Generally, large institutional investors (think of a pension plan or a sovereign wealth fund) can’t swing trade because their size prohibits them from easily moving into and out of a position. Smaller traders, however, can profit from these short-term movements because their size allows them easier entry and exit from liquid positions.

Swing trading is different from day trading or buy-and-hold investing. Those types of investors approach the markets differently, trade at different frequencies, and pay attention to different data sources. You must understand these differences so you don’t focus on aspects that are only relevant to long-term investors.

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.

What Swing Trading Is to You: Determining Your Time Commitment

Getting started in swing trading requires some reflection. Before you rush out to buy that top-of-the-line laptop or set up that brokerage account, you need to think about what kind of swing trader you want to be. (Yes, swing traders come in different shapes and sizes.)

Your first step is to determine just how much time you can commit to swing trading. You may be a full-time swing trader from your home, in which case you should consider yourself as trading for a living. Or you may be doing this part time for income with the intention (and hope) of becoming a full-time trader.

Many swing traders have full-time jobs and have little time to devote to trading, so they trade primarily to improve the returns of their investment accounts. Or perhaps they’re already in retirement and swing trade to grow their assets over time. These swing traders watch the market during the day but rely on orders placed outside market hours to enter or exit their positions. And if they trade in tax-deferred accounts, like an IRA, they can ignore the tax issue (until they begin to withdraw money from their tax-deferred account).

Remember The point is, you can swing trade whether you have a full-time job or not, but you need to make adjustments depending on whether you’re able to watch the market all day. And by the way, watching the market all day long doesn’t necessarily improve your returns. In fact, doing so can lower them if it causes you to overtrade or react to market gyrations.

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.

Remember 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).

Warning 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.

Sneaking a Peek at the Swing Trader’s Strategic Plan

Plan your trade and trade your plan.

Fail to plan and you plan to fail.

Countless clichés address the importance of a trading plan. A trading plan is the business plan of your trading business. Without the plan, you’re likely to fall into the trap of making things up as you go. Your trading will be erratic. You won’t improve because you won’t have the records on your past trading. You may think your trading plan is in your head, but if you haven’t written it down, for all intents and purposes it doesn’t exist.

Throughout this book I cover all the important parts of swing trading strategy in detail. In the following sections, I preview the critical parts of the strategy, trimming them all down into one neat little package. (For more on your trading plan, see Chapter 10.)

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:

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.

Remember 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.

Establishing your analysis techniques

Swing traders rely on two major analysis techniques: technical analysis and fundamental analysis. Technical analysis, broadly speaking, encompasses chart pattern analysis and the application of mathematical formulas to security prices and volume. Fundamental analysis covers earnings, sales, and other fundamentals of a company or a security. Fundamental analysis also includes the analysis of events or news that may drive a security price higher or lower (for instance, an earnings report, a new CEO, a new product, a government regulation change, and so on).

In my experience, most swing traders rely solely or in large measure on technical analysis. However, I explain both analysis techniques in this book because I strongly believe that understanding and using both improves the odds of success.

Both analysis techniques have their advantages:

  • Technical analysis can be quickly and easily applied to any market or security. For example, a trained swing trader can use technical analysis to quickly decide whether to buy or sell a security using chart patterns of technical indicators. In contrast, a swing trader relying on fundamental analysis needs more time to read about a company, its business, and its earnings before coming to a conclusion — or be more skilled in understanding how an event will impact the shares of a company or the sector. Whether you’re trading commodities, currencies, or stocks, you can apply technical analysis uniformly to these markets. In other words, if you know how to interpret a chart, then the kind of security being plotted is largely irrelevant. In my opinion, the ease of application is the biggest advantage technical analysis has over fundamental analysis.
  • Fundamental analysis can answer questions that are beyond the scope of technical analysis, such as, “Why is this security price moving?” Swing trading based, in part, on fundamentals is like having a head start in the 100-meter dash. Rallies and declines that are driven by fundamentals are more profitable to trade than rallies and declines that are simply the result of noise in the markets (such as a large mutual fund liquidating or buying a position). Over the long term, security movements are driven by the securities’ underlying fundamentals. Crude oil prices rise when demand exceeds supply or when supply becomes scarce — not, as technical analysis may superficially indicate, because the chart developed a bullish formation. (Of course, crude oil — or any security — can rise or fall due to non-fundamental reasons. But such rallies and declines are often fleeting and not as strong as fundamentally driven price moves.)

    Tip Some swing traders shy away from learning about a company’s fundamentals. Generally, fundamental analysis is seen as long, laborious, and not always right. But you can improve your swing trading by getting to the essence of a company’s fundamentals, even though it does require extensive reading, researching, and understanding of the drivers of an industry.

Remember Just how much should you care about a company’s fundamentals? The general rule of thumb is that the longer your investment horizon, the more important fundamental analysis becomes. The shorter your horizon, the less important fundamental analysis is in trading securities. This is because short-term movements are driven by momentum, noise, and other factors. Over the long term, however, fundamentals always win out.

But just because you understand how to apply fundamentals doesn’t mean you’ll make money. Markets don’t rise simply because they’re undervalued, or fall simply because they’re overvalued. Markets can remain under- or overvalued for long periods of time. That’s why I don’t recommend swing trading on fundamentals alone. Fundamental analysis tells you which way the wind is blowing so you’re prepared, but technical analysis provides the important timing components.

Choosing candidates to buy

You can find promising securities in two main ways — the top-down approach and the bottom-up approach. Both are covered in detail in Chapter 8, but here’s a brief rundown:

  • Top-down: Swing traders who prefer the top-down approach identify opportunities beginning at the market level, drill down to the industry level, and finally look at individual companies. If you fit this category, your entry strategy should begin with an examination of the overall markets, then trickle down to the major sectors in the market, and then to the industries within the strongest sectors. At this point, you rank the securities in the industry on some technical or fundamental measure (more on that in Chapter 8). Then you select the securities that meet your entry strategy.
  • Bottom-up: Swing traders who use the bottom-up approach are grassroots-oriented individuals who look for strong securities and then filter promising ones by their industry groups or sectors. If you fit this category, your approach begins with a screen of some sort (a screen is a quantitative filter), sometimes depending on whether growth or value stocks are in favor at that particular point in time. If that’s the case, you then compare the relative strength of the growth and value indexes (and possibly also the market capitalizations of the market). After identifying which securities rank highest in the screen, you determine which securities meet your entry rules, and then you trade only those securities that reside in leading industry groups.

Planning your exit

Most swing traders focus almost entirely on their entry strategy, but it’s the exit strategy that determines when you take profits, when you take losses, and when you exit a meandering position so you can put the capital to better use. So although planning your entry is important, you need to spend equal (if not more) time on your exit.

Remember Your exit strategy is most likely going to be technically driven, and it’s threefold:

  • Determine when you exit for a profit. Don’t take profits based on a gut feeling — rely on a trigger or catalyst instead. For example, some exit strategies for profits stipulate that the time for departure arrives when prices reach the implied target based on a chart pattern, or when shares close below a moving average.
  • Determine when you exit for a loss. Your exit strategy for losses should be based on the breach of a support level or some type of technical indicator (for example, the nine-day moving average). (Support levels are simply price zones where securities stop falling, and resistance levels are price zones where prices stop rising.) This keeps your losses limited to some known quantity (barring, of course, a gap down in the security price, which must be addressed by proper position sizing and other risk management techniques).
  • Determine when you exit if a trade generates neither significant profits nor major losses. That is, it meanders sideways and results in dead weight. Some swing traders exit a position quickly if it doesn’t perform. I prefer to give a position a few days to prove itself one way or the other. So I recommend exiting a position after ten days if it hasn’t hit your stop-loss level or triggered a profit-taking signal.

You should outline your exit strategy by making sure your trading plan addresses when you exit for profit, loss, and capital redeployment.

Being in or out of the market

Swing trading is most profitable when a strong uptrend exists and prices are moving higher. However, sometimes the market is weak and trading profits are hard to come by. In such situations, I recommend you exit the market and sit on the sidelines (or turn your attention to a foreign market that is rising consistently).

Although some techniques do permit traders to profit from declines in the market, I don’t use them nor do I recommend you do. The risk payoffs aren’t favorable and the costs of such a strategy are higher. Over the long term, stock indexes have risen worldwide so trading against the long-term trend can prove costly if executed incorrectly. A swing trader can achieve double digit returns annually without the use of leverage or engaging in trades that profit on the downside.

Preparing your risk management plan

The most important part of your trading plan is how you manage risk. Risk management, which I cover in detail in Chapter 10, addresses how you manage risk on an individual security level and on the portfolio level as a whole. A trading plan with a weak entry strategy and a weak exit strategy can still be profitable if the risk management strategy limits losses and lets profits run.

In order to effectively manage your risk, you need to account for the following aspects of your trading plan:

  • How much you risk on an individual position: Your trading plan must spell out how much you plan on allocating to a single position. Because I’m unable to predict which of my trades will do exceptionally well and which ones won’t, I equally allocate across my positions (meaning, each security gets the same weight).
  • How much you risk of your overall portfolio: You determine how much of your total portfolio is at risk on a single position. Generally, this figure should be 0.5 to 2 percent (see Chapter 10).
  • How to achieve proper diversification: Diversification means more than adding several securities. You need to have exposure to different asset classes, sectors, and market capitalizations.
  • When you’ll be in the market and when’ll you be out: Falling markets can destroy your account value. Therefore, you need specific rules that govern when you’ll be in the market (or open to buying stocks) and when you’ll be out of the market and utilizing cash as a safehouse.
  • How you implement the 7 percent rule: How much you risk on a single position is different from how much you risk of your total portfolio. The 7 percent rule caps your total risk at 7 percent (refer to Chapter 10).
  • How you determine your exit points: Your exits should be driven by support and resistance ranges, technical indicators, and profit targets.
  • What triggers an exit: An exit may occur due to a loss, a profit, or a lack of meaningful market action.
  • How you manage your emotions: No matter how effective a risk management system is, a human being (in this case, you) ultimately must enact it. Thus, this last point is paramount, because humans are affected by emotions, experiences, and hopes. This fact can cause swing traders to abandon the stringent rules they’ve developed and make an exception for an existing holding or prospective purchase. Unfortunately, not following trading rules will eventually lead to financial ruin.

    I’ve found that managing emotions is the most difficult aspect of swing trading. The better you get at trading, the more likely your emotions will convince you to cut corners and abandon the rules that got you to where you are. But emotions can be managed. You can limit their impact by, for example, implementing stop-loss orders that get you out of a security without your interference.

The preceding bullets all boil down to two categories of action: position sizing and limiting losses at the portfolio level. So what’s the difference between the two? Alexander Elder, a trading expert, once differentiated between losses suffered at the individual stock level and the portfolio level through an analogy of sharks and fish. Specifically, he said that position sizing is done to reduce the risk that your portfolio will suffer a “shark bite” loss from a single position. That is, a single major loss that wipes out your account value.

On the other hand, portfolio risk management is done to prevent several small losses from killing you — or as he described it, death by piranha bites. A single small piranha may not be able to kill a larger mammal, but dozens of piranha working together can be deadly.

Similarly, a small loss is not life threatening for a portfolio. The risk is that several small losses may gang up and cause major loss. That’s why you must limit losses on an individual stock level (and avoid those shark bites) while also limiting losses on the portfolio level (to prevent death by piranha bites).

Building Your Swing Trading Prowess

Staying on top of your game means you can never stop learning or improving yourself. Sadly, you can’t simply become a swing trading extraordinaire and implement your trades with nary a single problem. Heck, a master martial artist doesn’t stop after earning his or her black belt — why would a swing trader?

The following action items will help you stay strong throughout your career as a swing trader:

  • Be a student of the markets. Successful swing traders never stop absorbing information. The markets are always changing, with new investment vehicles appearing and new laws being introduced. As a swing trader, you must maintain intellectual curiosity. Reading books is one way to continually stay informed. Take an interest in understanding your positions and reading the pro and con arguments on them.
  • Remember Try to insulate yourself as much as possible from others’ opinions, whether the person is an Average Joe or a Wall Street analyst. Remember, Wall Street is a community, and analysts send out their opinion reports to thousands, if not millions, of clients, traders, and portfolio managers. Reading those reports can lead you to think like the analyst does — and like countless others do. Good performance doesn’t come by copying what everyone else is doing. Read books, weekly magazines (such as The Economist), or studies published in academic journals. Don’t read stock reports; they’re marketing materials.

  • Admit to losses when they occur. Markets have a way of humbling even the most skilled traders if they let their egos get in the way of their trading. Some traders hold onto losing positions in the hopes that they can eventually break even — a policy that devastates an account in the long run. A losing position not only may lose more money, but it also ties up capital that could be invested in more promising trading opportunities.
  • Don’t look for guidance or data from Twitter, Reddit, or message boards: Avoid online community forums where traders and investors talk up or down stocks. Although the idea of sharing notes with others on the Internet sounds appealing, the reality is these communities foster groupthink and are inundated with hype and hysteria instead of facts and data-driven research. Form opinions from unbiased sources (like Yahoo! Finance or financial statements of stocks you trade) and steer clear of community forums.
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