In This Chapter

Swing trading is a strategy that capitalizes on price tendencies of some stocks to move in a certain direction for short periods before reversing. This “swinging price,” from up to down, gives active traders a window of opportunity to make some money. It is not easy money (nothing about active trading is easy), but it can be lucrative.

Swing traders look for profits they can ride for one to four days or even a week or more. This requires discipline because it is impossible to know when a stock will hit a top or bottom price. Swing traders look for stocks that will move on news, but not necessarily by huge amounts. They look for larger profits than the short-term traders we met in Chapter 3, but they know that greed could cause them to hold a stock until the price goes down.

Traders use technical analysis to identify when certain conditions are right for a stock to start moving either up or down. However, swing traders also rely on fundamental data to inform their decisions, especially when identifying potential trading candidates. Because the holding time is longer than the holding time for short-term traders, the swing trader is at some risk of economic or company news derailing the trade. But there are also some higher-risk trades the swing trader can enter (with eyes open) that offer the potential for a bigger payoff.

Swing trading may be a good alternative or addition to short-term trading. It requires some more work on the front end to identify the right type of stock. You will also want to become familiar with the best market conditions for swing trading.

The swing trader identifies a stock that is beginning a one- to four-day upswing in price, which is usually followed by a corresponding retreat. In most cases, these swings occur when the overall market is not blowing hot or cold but trudging along “sideways.” Major stock indexes may not move up or down much from week to week, and stocks, especially stocks of larger companies, fall into a price oscillation above and below a baseline price.

When the market was crazy with tech and Internet stocks, swing trading became very popular. There was so much new (and undisciplined) money rushing into the market, big swings of 10 to 20 to 30 points were available for professional traders. Big run-ups of stocks and corresponding crashes were common, and swing traders made money going both ways.

After that market imploded in 2000, the swings became much more tame and realistic. It is not likely we’ll see that kind of over-the-top market again, but swing traders are well-positioned to take advantage of stock runs of any size if they know how to use the tools available to them.

The idea behind swing trading is that stock prices will rise in steps or swings, each lifting the price up to a new high or lowering it to a new low. The ideal candidate steps up in price from one level to the next with regularity. A chart will show how this works as swings push the price to new highs. A swing trader can find the entry point by observing a historical chart and seeing a pattern in how much the stock retreats after an upward swing. The chart will show highs and lows for the day and, when included over a long period, you can see the previous swings that elevated the stock to its current price.

Not all swings come neatly wrapped and easy to identify. By their nature, most swings are in small increments and last for short periods. Frequently, traders look for days when the market is not going up or down with any strength. During these market days, some stocks can be identified as good swing candidates. Large-cap stocks work well for many traders. These stocks of larger companies that are not moving on any particular news often swing up or down over a period of several days.

Many swing traders work with strictly technical analysis. However, a number also use elements of fundamental analysis to spot longer swings or stocks that may be moving up due to strong earnings or other corporate news. The best swing traders use a combination of both to find the best candidates. Fundamental analysis looks at key financial components that change and create news (earnings, SEC filings, insider trading, and so on). These often signal a stock that may be a good swing trading candidate.

Using daily charts, swing traders can catch one of the swings and ride it for a nice profit. How does the trader know when to get in and get out? We’ll discuss that in greater detail in Chapter 19 when we look at actual swing trades. But for now, consider that the swing trader is using the stock’s baseline price as a reference point. The techniques for profitable swing trading involve technical analysis of the stock’s price relative to this baseline.

Tools for fundamental analysis may help you identify a potential candidate for swing trading, but most traders rely on technical analysis to help them identify entry and exit points. Once you find a good candidate for swing trading and the market is right, you can use technical analysis research tools offered by your direct access provider, broker, or third-party vendor (you don’t necessarily need a direct access provider, although many part-timers use one) to calculate a price baseline for the stock. The baseline will be a moving average—a 20-day moving average is common—that is your reference point (more about moving averages next). When the stock price moves above this baseline, you buy, and when it dips below the baseline, you sell or short. It’s somewhat more complicated than that, and we’ll see how it works with several variations in Chapter 19.

The key to successful swing trading is no different from any other type of trading or investing. You must be disciplined about when you buy and sell. You can’t control the price of any security you buy, but you can control your entry and exit. Swing trading is good training for the discipline all traders and investors need to be successful.

Technical analysis uses moving averages to establish baselines and for other measurements because they give you a picture of what a stock’s price or sales volume is doing over time. Moving averages (MA) eliminate the fluctuations that can be confusing by smoothing out peaks and valleys of price changes. Charts developed from MAs give you a sense of momentum (or lack of momentum) in price or volume changes. They are used for other aspects of technical analysis, but we’ll leave that discussion for Chapter 16. An MA can look at any period, and two periods or more are often combined on the same chart to contrast changes and spot trends.

An MA is easy to calculate, although most charting software or direct access provider platforms will do the work for you. Here’s how to calculate a simple moving average (SMA) of these hypothetical stock prices:

This is the average. To calculate the MA, we add a new price (17) on the end and drop the oldest price (15):

Each day, the oldest price drops off, the newest price is added, and the average is recalculated to give you a moving average.

A simple moving average is helpful for a number of trading and investing strategies, but many swing traders want something that is more responsive to current price changes. For this information, they turn to exponential moving averages, or EMAs. These tools take simple moving averages and give more weight to recent price changes. This is important to swing traders since timely changes mean more than historical ones. The calculation is more complicated and it’s best to rely on your software to make the calculation.

The benefit of using EMAs is that they respond more quickly to price changes than SMAs do. This is important for swing traders because a stock price increase will raise the EMA sooner (and a price drop will lower the EMA sooner) than using the SMA. When you are using very short-term EMAs, this is important. As the EMA is plotted against the baseline, you will see a buy or sell (short) signal developing. The sooner that signal makes itself apparent, the sooner you are in a position to make a trade decision.

Since swing traders are most interested in what’s happening now, they may focus on EMAs of some length for establishing a baseline for a stock. This is where the stock will trade during a good (fairly flat) market for swing traders. The market will drift up and down with little permanent movement in either direction. In this type of market, the swing trader can follow a stock up for several days as it rides the market and reverse his position and ride the stock back down, taking profits both ways. This is somewhat of an oversimplification, but the process is the same for swing traders: riding a very short trend in either direction.

In many cases, a stock will trade between a high and low value rather consistently. These barriers are called support on the low side and resistance on the high side. The area between these two levels is called a channel. When a stock breaks through resistance on the high side, it is considered a signal to buy. If a stock drops below its support level on the low side, that’s a signal to sell or short. We’ll explore these terms and their significance in detail in Chapter 16 when we look at technical analysis.

This sounds simple, but the trick is identifying the right market conditions and stock for this type of swing trading. While you can plot a strategy that watches short-term averages cross the baseline to determine your entry point, there is no guarantee the stock will follow the swing for you. It could briefly rise and then abruptly reverse course, shattering your strategy.

While swing traders don’t usually need to watch every tick of the market like day traders do, it is important to pay attention. Most traders of all vari- eties use special instructions to their brokers to protect themselves from significant losses. We’ll discuss those stock orders and strategies in Chapter 13 and see how they apply in several other chapters.

Swing trading is not easy, but it may be the best place to start for people just beginning in active trading. It is possible to do swing trading part-time until you get the hang of it. You are not required to watch intraday prices like short-term traders must, so your level of detailed information doesn’t have to be as deep as that of day and momentum traders. You can subscribe to charting services if that information isn’t available through your discount broker. In other words, it is possible to part-time swing trade on the cheap.

However, if you are interested in making real money, you must do your trading full-time. Part-time swing traders will only have time to follow a few trades.

While full-time swing traders don’t do the dozens or more trades a day that short-term traders manage, they are prepared to take on multiple trades as the market provides opportunities.

Professional swing traders, like most other traders, follow a routine in the trading day that prepares them before the market opens, keeps them informed while stocks are trading, and provides a period of reflection and evaluation at the end of the day. The two primary tasks each day are gauging the market sentiment (bull or bear or flat) and finding possible trade candidates. Although markets don’t generally reverse their long-term direction quickly, they will bounce back and forth depending on economic and corporate (earnings) news. A market that has been in a general decline can be lifted by good news, and a climbing market can stumble over bad news. String enough good news or bad news together and the market can begin a long-term reversal.

Swing traders are not really concerned with where the market is going to be in six months; they are concerned with what will move the market today or tomorrow.

That’s the type of news they can make money on because it will lift or depress stocks. When there is not much happening in the market and there is little in the way of economic or corporate news to shake things up, swing traders can use a strategy of riding the rise and fall of stocks within their channel to keep making money if they are clever. Short-term traders may be yawning and wondering where they stored their golf clubs in this type of market.

The other difficult task is identifying good candidates for swing trading. There are a number of strategies—using news of fundamental changes is one—to spot good candidates. Then it’s a question of choosing the right stock for the current market conditions. Traders may have a favorite group of stocks that have exhibited in the past a predictable swing pattern. They may also look for new opportunities in sectors that are hot, using exchange-traded funds (see Chapter 8) to work the sector for profits.

As noted previously, some swing traders will stay glued to their charts looking for the right patterns to tell them a swing is underway or about to begin. Without considering what is happening in the world about them, technical analysts run the risk of being blindsided by news that will wreck the swing pattern for better or worse.

Relying solely on fundamental news or technical analysis is fraught with peril. Keeping up on financial and economic news tells traders if the market sentiment is bear or bull. This knowledge is helpful to swing traders because it tells them what to expect in intraday trading. Likewise, ignoring what charts can tell you, especially on days when there is no market push in either direction, means you will miss opportunities.

Although swing traders usually hold a position for one to four days, the truth is they will hold it until in hits the point where the traders believe the potential for reversal is too high and it’s time to take a profit—in other words, when the risks outweigh potential future gains. That may come quickly if the price stalls or reverses itself or it can stretch out for several days. Traders will often decide before entering the trade where that point is and plan to exit when the stock hits the target price. This means you’ll leave some money on the table when some stocks go up after you exit. However, it also means you will avoid a loss or a much-reduced profit if the stock suddenly does an about-face.

Swing traders, like short-term traders, aren’t trying to wring every penny of profit out of every trade. They know that is the riskiest strategy of all. It is better to set a profit goal and capture that and set a maximum loss and exit at or before that profit. This strategy is money management, and it will keep you trading long after high-rollers have lost everything and entered a career in the food service industry.

Many novice traders spend most of their time identifying and buying stocks and don’t give enough thought to an exit strategy. In short-term trading, prices can change so quickly traders often set a target profit and when that price is hit, they sell. They absolutely have a maximum loss in mind when they make the trade. If the stock dips to this price, it is automatically sold, thus limiting their loss to a pre-determined amount. Swing traders must have the same discipline with some variations.

Before they enter into the trade, swing traders must determine how much risk they are willing to take. Ask yourself, “How much of a dip in price will I tolerate before closing (selling) my position?” Once you determine this level of risk, don’t back off of it. Don’t take on more risk in hopes a bad situation will get better—that’s how you lose money. You must learn, as the short-term trader must every day, that it is better to take a small loss and move on than to take more risk and lose big.

When it comes to a winning trade, the swing trader sometimes has an advantage over the short-term trader. You should have an exit price in mind. However, if the stock keeps rising and is not showing technical signs of slowing down, you can move your exit price up so that profits are locked in. When the stock does show signs of resistance, you can exit. This is a distinct advantage for swing traders: the latitude to let winners run, but keeping an exit price under them to protect their profit. Traders should also stay on top of news that might create a fundamental reason for a price change. Technical analysis is a wonderful tool, but it can’t predict the CEO of the company being charged with cooking the books.

Short-term traders have little need for research. They don’t care what company they are trading or what it does. Swing traders, however, do benefit from research. Their research is focused on identifying potential trade candidates, which means finding stocks that may be ripe for an upturn or downturn in price due to an economic or fundamental trigger. They are not attempting to calculate what the stock’s price will be in a year or six months or even six weeks. Swing traders are interested in stocks that look like they could move today or tomorrow.

For example, when large bellwether stocks like Microsoft or Intel report earnings, other technology stocks may rise or fall based on how well or poorly the news is received by the market. Swing traders may know that a certain stock or group of stocks reacts to news of certain industry leaders, so they trade these stocks rather than the industry leaders. In other cases, news of mergers, buyouts, initial public offerings, and other major market news may create opportunities.

Most traders try to find opportunities for the most reward with the least risk; however, there is always some risk. Traders calculate the amount of risk relative to the potential reward to determine if a trade is in their best interest (this is true of investors also). Taking a risk is not a bad strategy if the trader knows the risks and believes the potential reward is large enough to justify the trade. Novices and traders who succumb to greed and fear will take wild risks that are often disproportionate to the potential reward. Worse yet, they will enter trades with no understanding of the risk or a misunderstanding of what the potential reward is.

Swing traders can take calculated risks when the opportunity presents itself in hopes of capturing a much larger profit than they might normally expect. One of the popular calculated risks is taking a contrarian position, or going against the market: you buy when everyone else is selling and sell when everyone else is buying. Experienced traders will employ this strategy around a fundamental news trigger with the idea that the market often overreacts. Some fundamental news triggers include mergers, acquisitions, initial public offerings, restructurings, and so on.

For example, an announcement of a merger of two leading companies in an industry can create a quick price bubble for some stocks in the same industry, which can deflate when the excitement cools. A clever swing trader might notice that the market is bidding up several stocks (thinking they might be acquisition candidates in an industry consolidation) beyond what was reasonable. Whether the stocks are candidates or not, it is likely that it will be some time before any other announcements are made.

If swing traders believe the potential reward is significant, they can short one or more of the overpriced stocks and wait for the air to come out of the price. If their strategy is correct, traders and others who rode the price up will sell and the price will fall. The further it falls, the more money swing traders make. Of course, if the swing traders are wrong and the price holds or continues to rise, they will have to cover their position for a loss.

This discussion has focused on stocks to keep the explanations simple and to emphasize the tools and techniques. Swing traders can use other types of securities, too, such as exchange-traded funds. We’ll go over those in Chapter 7.

The Least You Need to Know