In This Chapter

Swing trading is not a new trading strategy, but it has enjoyed a resurgence of sorts. Thanks to a stock market that has been all over the place, short-term traders have needed more than one way to make money. Bull markets, bear markets, and flat markets may require a different approach if traders are going to be successful. Swing trading is one strategy that can work well in a flat market, which comes along ever so often and frustrates those strategies that thrive on volatility.

Like other forms of trading, swing trading is not precisely defined in the investment community. Some lump it and momentum trading together, while others, including this book, separate the two. Swing trading can be less risky than very short-term trading, although some strategies, such as pursuing news-driven gains, can be just as risky.

Swing traders, like their shorter term associates, momentum traders, understand the power of the trend. While there are valid and successful contrarian strategies, most successful traders work with the energy behind trends and not against it. Trends push stocks up (or down) until something stronger stops them. The “something” is always sellers outnumbering buyers. Swing traders follow a stock up and exit before it hits the wall of sellers. They may reverse their strategy and short the stock as it slides back down before hitting a floor of buyers. The traditional swing trader will cover their short before the price begins to rise on buying pressure and begin the cycle all over again.

It sounds simple, but finding the right stock in the right market makes swing trading a bit more complicated than this summary. However, swing trading is not as intense as scalping, momentum, or any other form of day trading. The longer holding period allows positions to mature and offers the possibility of larger profits. Along with that increased potential for a higher return is the risk that holding open positions brings. Most active traders believe the longer they hold a position open, the longer they expose themselves to the possibility that business, economic, or market factors could undermine profits. With proper safeguards in place (discussed below), swing trading doesn’t have to entail unnecessary risk.

Swing trading is often recommended to beginning traders as a way to gain an introduction to the markets without the intense pressure of short-term trading. It is possible to execute swing trading strategies without a direct access broker and expensive technology. You can do swing trading on a part-time basis while holding a regular job—something not recommended or even practical for short-term traders.

Not every trader approaches swing trading as a part-time strategy, however. Some traders use it as their full-time trading strategy and they use many of the same tools that short-term traders use. If the market is right and you want to build to this level of involvement, swing trading offers large potential profits. However, like all forms of active trading, you should ease your way into the strategy by learning as much as you can through paper trading.

Swing trading has an advantage over short-term trading because you don’t need to watch every tick of the market to be successful. That takes much of the pressure off beginning traders.

Swing trading and momentum trading are sometimes confused because they both take advantage of trends. However, there are several differences. Momentum traders close out their positions at the end of the trading day, if not before. Swing traders may hold a position for several days or weeks while an intermediate trend exhausts itself. Momentum traders look for a stock that is headed in one direction with strong daily volume pushing it. Swing traders look for a stock that is trading in a range or channel and try to profit as the price rises and falls in a broad range.

One of the most important tasks for a swing trader is finding the right stock combined with the right market, which we discuss below. Many swing traders find that large-cap stocks work well for their strategy. Large-cap stocks tend to be more stable companies that trade in a somewhat predictable range. Unlike smaller companies, these giants set the market rather than bend to it. Because of their size, most of these companies are highly liquid and trade millions of shares on a typical day, which is helpful to the swing trader.

Depending on the market conditions and how traders employ their strategy, swing traders will look for a trading candidate with certain attributes. In a flat market where the major indexes are drifting up and down with no obvious direction, swing traders may focus on large-cap stocks that will follow the indexes and coast along, sometimes up and sometimes down, but within a trading range.

Company news such as earnings reports can create an opportunity for swing traders to pick up on an upward (or downward) trend in prices that often overshoot the ultimate price. For example, if a company reports better-than-expected earnings, the market may bid up the stock over several days. Sometimes the enthusiasm drives the price past the point where sellers want to take profits and the price falls. Swing traders can capitalize on both swings, if they have a clear view of both movements. The upside requires a quick entry or you will miss the early gains. Traders should plan on an equally quick exit, when selling pressure begins to build and the swing looks to reverse direction.

Swing traders can also “fade” the market by taking a position that is contrary to the bump created by news. The play here is that the market will overreact and when it corrects, swing traders will profit as prices swing back. For example, if a company announces a merger possibility, the market may bid the price up quickly. Swing traders would short the stock near the top in the belief that when reason returns, the price will fall back as it often does. When the price does retreat, swing traders cover their position for a nice profit.

This is a risky strategy. The price may continue to rise or not retreat. In either case, traders must cover their position quickly to avoid further losses.

When the markets are more volatile, swing traders spend a lot of time studying news wires and industry reports to identify companies that may have a special situation such as major economic, sector, or business news that will push them out of a flat trading range into a new channel. These present an opportunity to ride a trend up to new highs and back down to a higher low. This is a riskier form of swing trading because you can’t know when a new trend will end abruptly, forcing you out of your position before you have made enough to cover trading costs. This form of swing trading is best done with access to Level II screens, although it is possible with just information from your online broker.

When the market is flat, swing traders can use exponential moving averages (EMA) to create a baseline price for a trade candidate. EMAs for the previous 10 to 20 periods may be sufficient to establish a baseline. You’ll remember that EMAs track closing prices, giving more weight to recent entries. This indicator is more reliable than a simple moving average and traders can use it to look for variances.

Plotting the baseline on a chart gives the trader a way to see if prices are trending above or below level. When prices push above the baseline, swing traders will go long after confirming the trend or short if the price dips below the baseline.

A relatively flat market prevents prices from bumping above or below the baseline in simply following the market’s influence. The trader wants to see the stock moving on its own rather than floating with the market. It is easier to spot trends and reversals if the stock is moving under its own energy (supply and demand) rather than getting a push from the market.

While most swing trades do not need precise timing (see trading on news for an exception), swing traders must still enter as soon as they are comfortable a swing is confirmed and exit when they see signs the swing is about to stop. The right stock will help make this possible.

Traders must trade in the market as it is. While many hope for the bygone days of previous markets, practical traders deal with what’s before them now. Although it is not always easy to tell what type of market you are in until after it is over, an observant trader can adjust strategies to accommodate reality. It is important to master a particular active trading strategy, but you will find having more than one tool in your box is helpful in dealing with different markets.

Swing trading seems to work best when the market is moving sideways—that is, it drifts up and back down as measured by the major stock indexes. Swing traders look for those stocks that will mirror the market in rising and falling with a significant point spread between the high and low. Significant may mean different things to different people, but three points would be a good spread between the high and low points in the swing. If traders are fortunate, it could be more. Traders want a stable market to keep the swing going back and forth, so they can profit on price movement in both directions. In a choppy market, swing traders are less certain of a swing and prices tend to be more erratic.

Consequently, short-term traders prefer volatile markets and don’t have as many opportunities in flat markets. That is why many short-term traders use swing trading as an alternative to match the market or set-up rather than forcing all their trades into one strategy. Seasoned short-term traders can spot a swing trade opportunity among their set-ups and switch strategies on the fly. Beginning traders should stick with a single strategy until it is mastered before moving to another. The value of having more than one way to make money in the market cannot be overstated. You will be presented many opportunities. Part of becoming a successful trader is understanding which strategy will work best on the opportunity in front of you.

In a market where there is no well-defined direction, major indexes may drift up and down without moving very far in either direction. For swing traders, this creates a good environment to find stocks to trade. This is not an absolute requirement because you can find stocks that will trade in a good range regardless of what major indexes are doing. Swing traders are looking for stocks that will move over a period of several days in one direction and then reverse back down to a previous level. This ideal stock gives swing trading its name as its price drifts back and forth from a high to a low over a short period of several days.

Like all set-ups in trading, you don’t always find the ideal situation. However, with some practice in learning what to look for, you can often find good swing trading candidates. In many cases, you may find that the stock doesn’t swing to a regular rhythm, but may swing up and hold for days or longer before drifting back down. This is not the ideal trade because traders lose the multiple profits of playing the swing both ways. However, if traders are clever, they will take their profits and not wait for a swing downward that may not be coming, especially if there are no technical indicators showing a break in the trend. At this point, traders can’t be sure whether the stock will continue up at some point, stay on hold, or retreat. Your best bet is to exit the stock until there a clear indication of where the stock is going.

In our discussions of short-term active trading, we noted that because of thin bid-ask spreads and other factors, traders often have to increase the number of shares traded to make a profit large enough to cover expenses. In that venue, trades of 1,000-2,000 shares are not uncommon. Swing traders hope for larger per share profits and usually don’t need to trade as many shares (unless you want to) as short-term traders. This opens swing trading up to many people who can’t afford the $25,000 minimum that pattern day traders must maintain in their accounts. If you are going to be trading frequently, you’ll want either a deep discount broker that offers breaks for traders or a direct access broker that has favorable arrangements for heavy traders. You will also want to consider how much margin you want to use because holding a position for several days will cost you something (but not much) in interest expense.

Swing traders can protect profits and reduce losses by using trailing stops or manually moving stops as the trend plays out. Either way, you build a floor of sorts under your profits in the event the trend experiences an unexpected sharp reversal. Unless you are attempting to time your entry and exit as close to the limits as possible, you shouldn’t have to worry about watching every tick of the market.

This will not be true for those less risk-adverse traders who want to fade the market on news-driven events. These traders should keep an eye on price movement to avoid a nasty surprise. Even with stops in place, it is not possible to be completely safe if you are trading close to the border between profit and loss.

A short visit to the Internet via Google will reveal page after page of swing trading systems—most boasting certain success. Can they all work as well as they claim? Probably not. Like most trading systems, swing trading systems offered for sale on the Internet or through other venues come in varying degrees of quality. Some are good quality, but only work well under certain market conditions, while some are so complicated it is a wonder they work at all.

This is not to say you shouldn’t use a system prepared by someone else. There are some good packages available on the market, although it is doubtful that any one system works in every market condition. If you are just starting out in swing trading, you will need a system of some type. Whether you develop your own or subscribe to one of the available commercial systems, you will need something to bring order to the world of swing trading.

Whether you develop your own system through practice and refinement or use an existing system, plan on paper trading for some time to become familiar with how the system works. Your trading system should evolve with your trading style. Don’t make changes during the heat of the trading day because you will not be thinking clearly at that point.

Most of the systems on the market use technical analysis to spot entry and exit points for swing trades. You will find proponents of technical analysis who insist there is no other way to trade. While technical analysis can improve your odds of finding good trades, it won’t guarantee them. Don’t be led to believe that charts and lines can predict something as uncertain as tomorrow’s stock prices with any consistency.

Given that warning, it would be a mistake to not learn the basics, at least, of technical analysis and how it can help you make better short-term and swing trading decisions.

Technical analysis can improve your chances of better entry and exit points. You would be foolish not to use these tools, but they come with a learning curve, so take the time to study and practice before committing money.

The end of each trading day is a good time for evaluation and reflection on the day’s activities and trades. How would you rate your performance as a trader? What tweaks (if any) do you need to make in your trading system? To help this process, it is important to document your trades and outcomes during the day. Most brokers provide reports covering your activity; however, those reports don’t say why you performed a task in a certain manner.

The Least You Need to Know