How To Add A Layer Of Discretion To Your Swing Trading

In my articles and book on swing trading, I strive to make the rules as specific as possible. However, the market doesn't always conform to specific rules. Therefore, you occasionally have to add a layer of discretion. Below I discuss a few ways in which discretion can be used to help improve your swing trading.

Good Close/Bad Close

In general, we are taught that "good" setup closes in the top of its range (for longs). The theory is that the buying that lifted the stock into the close will continue on the following day. However, there are times when stocks that closed poorly might be considered. One such case is when market conditions themselves are poor. A stock with a poor close is less likely to trigger on the following day, should market conditions remain poor. This will help to keep you out of the market during these times. On the other hand, if the stock does trigger, it suggests an impressive reversal as the stock was able recover all of the prior day's losses. And, it could suggest a major reversal back into the direction of the original trend. 

This brings us to another form of discretion, fading gaps. 

Fading Gaps

Stocks that close poorly (for potential longs), often gap lower on the following day, as existing longs "throw in the towel" and new shorts are attracted to the market. The gap down can often represent a panic low or near low for the day. In the case of a pullback (or any setup for that matter), you might look to enter in the direction of setup and  against the direction of the opening gap, provided it shows some sign of reversing back into the direction of the underlying trend. Often, this allows you to get a head start on those that won't be triggered until the prior day's high is taken out. This is illustrated below and discussed in further detail in my article "Opening Gaps: Trade 'em, Fade 'em or Ignore 'em".

Early Entries

In addition to fading gaps (mentioned above), there are occasions where you might look to enter a setup before the actual trigger is hit. I've dubbed this "front running" a setup.  This usually works best when the setup is very obvious -- possibly "textbook" in nature. In these cases, provided the market and the sector are in gear, you might look to enter just below the obvious entry (usually above the prior high for longs). You can then use a tighter-than-normal stop and look to re-enter just in case you are too early. 

Higher Entries

In general, unless the setup dictates otherwise, the entry (for longs) is normally just above the prior bar's high. However, there are instances where you might want to enter above the prior 2-3 (or more) bar highs. The best case for a higher entry is when the recent highs are fairly close to the prior bar's high. The advantage is that the stock might not make it through this resistance level and you will avoid a potentially losing trade. And, because the entry is only slightly further away from a "normal" entry, you don't give up too much of the stock's move. This is illustrated below.

5, 10, 15, 20, 25?

When the exchanges implemented decimalization, I quickly realized that professionals were often able to push stocks at least 1 cent above/below the prior day's high/low, in order to trigger stops. Therefore, I immediately begin using at least 5 cents above/below the prior high/low for entries. 

Taken one step further, I also discovered that if a stock closed well (for longs), I wanted my stop even further away to help ensure that I would not get caught in a false move. Why? Because stocks that close well have a very good chance of showing some initial follow-through but after that, there's no guarantee the stock will continue higher. Therefore, by placing an entry well above the prior high, say 10 to 25 cents depending on the close, I was able to avoid these false moves.  

On the other hand, on a poor close, the stock is less likely to trigger on the following day. And, if it does trigger, it shows that the stock has very strong intraday strength. Therefore, when a stock closes poorly, I usually place an entry stop very close to the prior day's high. In fact, on a very poor close, I might put the entry at the high or even look to enter early (before the trigger).

Second Entries

In choppy markets, the first move a stock makes will often be a false move. Therefore, in these instances, you might want to allow a stock to trigger and observe its behavior before taking a position. By avoiding the first push, you can then look to position yourself if and only if the trend resumes. The advantage is that you will often avoid a losing trade, should the stock reverse and never "re-trigger." Obviously, the trade-off is that you risk missing a winning trade should the stock trigger and keep on going.

Notice above that the stock pushed above the entry (a) but immediately reversed (b). In choppy markets, the original trigger can often be the high or near high of the day. Waiting for a second entry (c) (possibly slightly above the original entry/intraday high) helps to ensure that the stock will keep going in the intended direction. 

Stocks often gap open to their high (or near high) for the day. Therefore, by waiting a few minutes to see if the gap "sticks," and then looking to enter above the morning range, often a losing trade can be avoided. 

I have illustrated this common pattern below.

Taking Partial Profits

Ideally, when taking partial profits, you should make at least the amount you risked on half of your initial trade. Otherwise, the winners won't be enough to cover the losers. However, sometimes, during choppy market conditions, the market will tempt you by coming within cents of your intended profit goal before backing off. During these times, you are often better off taking the less-than-ideal partial profit. 

This is illustrated below.

On the other hand, if a market is really flying, you might want to trail a stop intraday to capture a greater-than-intended partial profit. 

This is illustrated below.

Protective Stops

Most of the time, the protective stop should go below the lowest low in the setup. If this is more than 5% away from the entry, I normally suggest not risking more than 5% of the stock's value. However, on lower-priced stocks and/or very volatile stocks, this stop probably has a better-than-average chance of getting hit. Therefore, you might want to use a somewhat looser stop and trade fewer shares. 

If the low of a setup is very close to the entry, say less than 2 points for a higher-priced stock, I might risk at least 2 points to help ensure that I don't get stopped out on the normal "noise" of the market alone. See my articles on volatility and Learning From A Loss for more information here. 

A Cardinal Sin?

As you know, I always preach the use of protective stops.  However, there are some cases where a stop could be pulled and then replaced. The most common argument for "pulling a stop" is when a stock is called to open sharply against your position. This is often caused by some sort of bad news, or events that transpire overnight. The next opening represents a potential panic situation as traders look to exit at the first possible chance. Often, these panic opens become the low or near low of the day. Therefore, in these situations, you might want to pull your stop and see if the stock will bounce within the first few minutes of trading. Keep in mind that this requires the utmost discipline and you must have an "uncle point" (i.e., where you will exit no matter what) just in case the stock gaps lower and keeps on going. This "repair strategy" will be covered in detail in an upcoming article. 

Trailing Stops

As you know, one of my favorite trailing-stop techniques is to use a 2-bar low. For instance, if on Monday the stock hits a low of 99 and on Tuesday hits a low of 100, then my stop for Wednesday will be around 98.90 -- just below the low of the prior two days. Now suppose that the stock had a sharp rally and closed at 110 on Tuesday. I might not want to give up over 11 points of profit (110-98.90). Therefore, I would likely adjust my protective stop to within several points of the closing price. On the other hand, if the stock closes very close to the bottom of its 2-bar low, I may want to give it a little more room, say a point or two below the close, provided of course the stock still looks promising.

In general, I tend to exit my swing trades within 2-7 days. However, I occasionally have the opportunity to hold a piece of position for extended periods of time. In these cases, I have already taken half of my profits when they exceeded my initial risk and have moved my stop to breakeven (see my money management lessons for details). Therefore, I essentially have a "free" position on the remaining shares (barring overnight adverse gaps).  I'm now in a situation where I can give the stock more room to breathe. So, rather than trailing the stop tightly, say at a 2-bar stop or some price percentage away, the stop could be placed below prior correction point/s (a). This longer-term stop could then be adjusted higher should the stock continue to "stair-step" higher. This is how what starts out as a swing trade can occasionally turn into an extraordinary longer-term gain.

To The Letter?

When I define a setup, I usually try to be as specific as possible. This helps to weed out lesser setups. However, many times the pattern doesn't fit the setup to a "T" but still may be worthwhile. In these cases, as long as I can justify the pattern from a conceptual standpoint, I  might still be interested. For example, with pullbacks, I normally like to see at least three but no more than seven days from the high (for longs). However, there are instances where I might find a stock that has only pulled back 2 bars interesting. By the same token, I might also consider stocks that have pulled back for more than 7 bars. For example,  in my stock column I mentioned Mentor Graphics (MENT | Quote | Chart | News | PowerRating) as a pullback after it had pulled back 3 bars. I continued to mention the stock even after the seventh bar because I felt, in the bigger picture, the stock was in a strong uptrend and had the potential to resume its rally.

The Ultimate Discretion -- Not Trading

Your own equity is the best measure of your performance and/or the performance of your methodology for the present market conditions.  Therefore, if your equity curve has been heading down of late, it may reflect either personal problems or poor market conditions for your methodology. It is at these times you might want to avoid trading altogether and then slowly ease back in when new opportunities present themselves. See "My Most Valuable Trading Lesson" for more on this subject. 

Taking It Further

In this lesson, I have barely scratched the surface on how discretion can, and probably should, be used in swing trading. I urge you to study these and, more importantly, develop your own layers of discretion through market observation and experience.

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