Ten Tenets Of Swing Trading

Swing trading is a method of trading which seeks to capture short-term gains in markets. It involves identifying markets that have the potential to make an immediate move, entering those markets and using strict money management to help protect against major losses and lock in profits. Trades are normally held for one to five days. Below we will look at ten general guidelines, by no means are exhaustive, but should help to keep you out of 90% of the trouble spots when swing trading.

1. Limit Losses

As soon as position is initiated, you should have a protective stop right below the recent support (for longs), or above recent resistance (for shorts). Swing trading often produces many small gains with only an occasional home run. Therefore, protective stops must be used on all trades. Getting careless on just one trade can erase many winners.

2. No Tickie, No Tradie

Swing trading involves identifying short-term support and resistance and where a market will likely re-assert itself. It is not about fading the market by picking tops and bottoms. Therefore, wait for follow through before attempting to enter a trade.

For instance, suppose a market is in rally mode and begins to sell off, chances are the next move will be a resumption of the original uptrend. However, until that uptrend begins to resume, positions should not be initiated. For longs, this means waiting for the market to turn back up, and for shorts, it means waiting for the market to turn back down.

3. Take Partial Profits Quickly

On most swing trades, the profits will be small and have the potential to quickly erode. Therefore, as soon as your profits (a) are equal to or greater than your initial risk (b), you should lock in half of your profits and move your protective stop on your remaining shares to breakeven (c) -- (near your original entry).

Locking in half of your profits and moving your stop to breakeven when your profits are greater than or equal to your initial risk,* will help to generate income for your account. This income will help to pay for the inevitable small losses associated with swing trading. Further, barring overnight gaps, this gives you, at worst, a breakeven trade and a chance at a home run on the remaining position.

4. Take Windfall Profits

As a swing trader, windfall profits are often few and far between. Therefore, you should lock in all or a significant piece of your profits when parabolic moves occur. After all, large moves occur as players dog pile onto a market as it becomes obvious to the masses. You've got to ask yourself, once it's obvious, and the last players are entering the market, who's left to buy?

As an example, notice below that Agilent Technologies (A | Quote | Chart | News | PowerRating) had a tremendous one-day gain (a), but all of those gains were eroded over the next few days (b)

5. Trade In Liquid And Active Markets

As swing traders, we are looking for an immediate short-term move. We don’t have the luxury of waiting around until a large price-move takes place. Therefore, the markets we trade in must be liquid and active so we can move in and out with ease, and hopefully, capture short-term fluctuations. Trading in thin and dull markets can be costly and will likely chew you up, as most short-term trading profits are small.

6. Stack The Odds In Your Favor

In trading, the more pieces of the puzzle that fit together, the better. Although in swing trading, we are looking for short-term setups, it helps to have longer-term factors in place. This can be in the form of momentum or big-picture technical patterns such as cups and handles, head-and-shoulders bottoms (or tops), double bottoms (or tops) and so on and so forth. These can be on daily, weekly or even monthly charts. Some of the best swing traders find markets that have the potential double or triple (over time) and look for short-term setups to capture a piece of that move. Also, for stock traders, the above should be combined with an overall market bias.

7. Enter The Entire Position At Once

In swing trading, we are in the market for a short period of time and looking for a swift move. Unlike the longer-term player who has the luxury of building positions over time and at an average price while waiting for the market to move, the swing trader is looking for an immediate move. In most cases, you should be looking to lock in profits and tighten stops as the market moves in your favor -- not add to positions.

If you must pyramid, then do it quickly as the position moves in your favor, and make sure it looks like an actual pyramid. In other words, only add to profitable positions and establish your largest position first. A 3-2-1 is good ratio for establishing positions. For instance, if your position size is 500 shares, then enter 300, then 200, then 100, provided of course, the market is moving in your favor while adding to the position.

8. Keep Position Size Within Reason

Swing trading is a game of probabilities. You win some, you lose some, and hopefully, through a consistent approach, you make money overall. Swing trading is not about trying to hit "home runs" by taking excessive risk on any one position. In fact, you should never take a position large enough to have a material impact on your trading account should -- or more likely, when -- a price shock occur.

9. Remain Consistent

Successful traders find a formula and stick to it. Swing trading is no different. You must find an approach that works for you and apply it in a consistent methodical manner. In addition to being consistent in your approach, you must also be consistent in your money-management techniques. This involves keeping position size within reason, using initial protective stops, taking profits and trailing stops.

10. When In Doubt, Get Out

In swing trading, we are looking for an immediate short-term move. If the market doesn't move immediately, then there's no need to remain in the market -- even if you're not stopped out. The longer you are in a market that is not moving in your favor, the more you are exposing yourself to a potential adverse move. In most cases, you're better off exiting the position and waiting for the market to set up again. A good rule-of-thumb here is to only take home profitable positions.

References and Additional Reading

*Larry Connors in Connors On Advanced Trading has dubbed this "2-for-1" Money Management.

Street Smarts by Larry Connors and Linda Raschke. A great manual for the swing trader.

Connors On Advanced Trading by Larry Connors. Contains a plethora of knowledge for the short term trader.

Four part series on Money Management, Position Management, by Dave Landry.

Trading With The Cup and Handle Pattern, Trading Pullbacks, An Introduction To Retracements, Combining Volatility With Structure by Dave Landry.