Swing-Trading Basics

A swing trader depends on the three emotions that dominate the stock market: greed, fear, and uncertainty. These emotions cause virtually all of the short-term price aberrations that make swing trading a profitable technical strategy. Swing traders try to ignore the tendency to react emotionally to price movement, using logic to take advantage of market overreactions. When prices of stocks rise quickly, "the market" (the overall investing market, that is) tends to act out of greed, buying up shares to get in on the anticipated profits.
The majority is often wrong, meaning that many people buy shares at the very top of a short-term price swing.

Smart Investor Tip

Swing traders bet against majority thinking, which often leads to exceptional profits because the majority is usually wrong.

When prices of stocks fall, investors fear further declines and want to cut losses. So the tendency is to sell shares at the very bottom of the short-term price swing. And after a period of price movement, stock prices may move into a very brief period of uncertainty. At these times, trading range narrows as traders wait out the next price movement. During uncertain times, some inexperienced investors become impatient and buy or sell impulsively.

All of these conditions present profitable opportunities, and this is where swing trading works best. Rather than timing decisions emotionally, swing traders tend to do the opposite of the majority. They attempt to time their sales for the price peaks, and time their purchases for the price bottoms. When prices settle down and the market is uncertain, swing traders wait out the period, moving focus to other stocks and practicing patience rather than making buy or sell decisions impulsively.

Swing traders buying and selling stock have to limit their activity based on cash available (on the long side) and margin credit (on the short side). So they typically can swing trade using odd lots only and limiting their participation to only a handful of stocks. In some cases, swing traders can afford to play only one or two stocks at a time, based on their capital restrictions. This is unfortunate because it means having to miss many opportunities. Options solve this problem while reducing risks and setting the stage to play both sides of the price swing without having to ever go short.

Smart Investor Tip

Swing trading with options presents a double advantage: you can be involved in many stocks at the same time, while costs and risks are lower than when shares of stock are used.

One argument against using options for swing trading is that they expire. But this should not be an issue because swing trading ideally works in a very short time frame. There is no need to tie up capital in buying (or selling) 100 shares of stock, when a single option contract provides the same dollar profit when price movement takes place.

Example

A Swinging Idea: A stock on your watch list is trading in the mid-40s and its trading range for 52 weeks had been $42 to $54 per share. Using the traditional method for measuring volatility, the stock was at 24 percent (range divided by low price). You wanted to swing trade this stock. To buy 100 shares, you would have needed more than $4,700 (on January 10, the stock was trading between $47 and $48 per share). To go short, you would have had to assume the risk of selling short, and had at least $2,400 in your account to cover the margin requirement.

Now consider using extremely short-term options. On January 10, slightly more than one week remained until expiration of the January options. There were only seven trading days remaining. This is a perfect scenario for extremely short-term in-the-money options for swing trading. Assuming a current setup signal occurred, you might anticipate a price rise (meaning you want to buy a call) or decline (meaning you want to buy a put). The January 45 call was about 2.5 points in the money, and was selling on January 10 for $2.37. This is virtually all intrinsic value. The January 47.50 put was selling that day for 0.60. So whether you believed in this situation that the price would rise or fall in the next six trading days, options are clearly much cheaper than 100 shares of stock.

The example makes a strong case for swing trading. But remembering that those options are going to expire in only six trading days, buying either the call or the put must be done only if and when a strong setup signal was present.

Smart Investor Tip

You can use options very close to expiration -- even a matter of days -- based on the swing-trading ideal of five or fewer trading days in any open position. But you also have to be willing to get in and out quickly or to accept small losses.

In most options strategies, you have to be concerned about the timing of a buy or sell decision primarily due to expiration, so the majority of strategies present a dilemma. On the long side, you want cheap options close to the money with a long time until expiration. On the short side, you seek high-time-value options with as short a time as possible until expiration. Swing trading contradicts these requirements, primarily because it is designed to work only within a few trading days.

In swing trading, you do not have strong feelings about companies one way or the other. You are trading emotions, not stocks. So when you find a setup to buy, you buy; and when you find a setup to sell, you sell. It's that simple. As a swing trader, you are exploiting the overreactions of the market at large and seeking very short-term profits based on identifiable setup signals. In the next section, a Wal-Mart example is detailed and the question of setup signals is explored in detail to show how this works.
By Michael C. Thomsett
Michael Thomsett is a British-born American author who has written over 75 books covering investing, business and real estate topics.

Copyrighted 2016. Content published with author's permission.

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