“Everything” You Need To Know About Swing Trading

One of the more popular Warren Buffett’s quotes states that “time is a friend of good businesses and an enemy of bad businesses”. When it comes to swing trading, it does not matter how much cash flow is a company generating and what its current valuation is.  The main two factors that matter for swing trades, which could last anywhere between 2 and 10 days, are industry momentum and price setup.

Price setups define the risk-to-reward and the probability of a breakout (breakdown) happening, but they don’t tell you the probability of following-through and the likely size of the move. It does not matter how perfect is the technical setup that you or your software have recognized. If you are not in the right industry, you are poised to achieve inferior results as a swing trader.

Industry momentum defines the likely magnitude of the move after a breakout (breakdown) and the probability of a breakout following through. Being in a “hot” industry could be the difference between a 20% after-breakout move and a 5% move, the difference between following-through and fizzling. Having an eye for industry momentum is the single most valuable skill a swing trader could learn.

There are a few other factors that impact the magnitude of the move, but they are of secondary importance: float (the smaller, the more volatile), market cap (the smaller, the more volatile) and short interest (the higher, the bigger the move potential).

Long time ago, Keynes said that “the secret to market success is anticipating the anticipations of others”. It is easier said that done, but there is a way. There is a constant industry rotation going on in the market and if we keep our eyes open and keep our personal, irrational biases in check, we stand a chance of figuring out where is the money flowing in real time.

How do we recognize that an industry is gaining momentum? One of the most simple ways is to pay attention to the number of stocks, gaining >4% in a day to new 20-day high in one industry (new 52-week high is even better). If several stocks from the same industry are simultaneously gaining momentum and having breakouts in short-term perspective, then the odds are that money is moving into that industry.

When an experienced trader sees an industry gaining momentum, his (her) instinct is to look for the next stocks in the same industry to break out. After all, such approach makes all the sense in the world. If money is going to a certain industry, sooner rather than later it is likely to lift all “boats” inside that industry. By focusing on stocks that have not broken out yet and are still building beautiful technical bases, we could allocate money to more favorable risk-reward setups. Sounds logic, right? The curious thing here is that if you study the performance of industry-related moves, you will realize that in the majority of cases, stocks that break out first, end up outperforming substantially. The very stocks that attracted our attention to an industry in the first place; the stocks that seemed too extended for a new entry, end up outperforming. Such is the nature of the market. It is often, counter-intuitive.

The goal of every swing trader is to achieve a 5% to 30% move in a 2 to 10-day horizon. Then to repeat that multiple times over the year by risking between 0.5% and 1% of capital per idea.

A few words on position sizing:

Let’s assume that your trading capital is 200k and you want to buy a stock at 40 with a stop at 38. You are risking $2 per stock. 1% out of 200k is 2k, which is your risk per idea. Your position size is 2000  : 2 = 1000 shares.

1000 shares * $40 = 40k, which is 20% of your capital

If it goes against you, in most cases you will lose 2k or 1% of your capital.

If it goes in your favor and the stock goes to 45, you will make $5 per share or 5k, which is 2.5% of your current capital. There are different ways to exit a profitable trade, but this is a topic for another discussion.