Many investors and traders who are building their knowledge and experience with investing and trading will wonder whether to get into swing trading for a profit and just how profitable swing trading can be.
First, we need to define swing trading and how it differs from day trading, scalping, and position trading or investing. So here are some straightforward definitions:
Swing trading is trading when the price is moving in a range between levels of support and resistance. Swing traders tend to hold positions for a few days to a few weeks and use a mixture of fundamental and technical analysis to find trading opportunities.
Day trading involves looking for highly profitable price movements that happen within a single day, also called Intraday. Day traders typically study a number of stocks, currencies, or commodities using technical analysis and might trade one to a few positions in a day.
Scalp trading involves seeking to profit from many small price movements that happen within a few minutes up to an hour or more. Scalpers typically trade many times a day and are looking for small but probable price movements in one direction.
Position trading is really more akin to what many people understand as investing. Position traders tend to be more conservative and are likely to ride short and intermediate-term dips. Position traders will also usually only enter positions on the long side and will use a blend of fundamental analysis to find stocks and ETFs and technical analysis to time entry and exit points. A position trader will tend to hold positions from a few months to a few years.
Interestingly you will find some other looser definitions of swing trading where the only distinctions between day trading, swing trading, and longer-term trading are the time frames involved for which positions are held. But then if swing trading was only about how long you hold a position, it would just be called intermediate-term trading, so why the reference to swing?
The reason it is called swing trading is that when stock prices move within a range between support and resistance they tend to swing from one level to the other until such time as they breakthrough and a new range is established.
Momentum vs mean reversion
There are at least two hypotheses that seek to explain how market prices behave. The two I am referring to here are pretty much the opposite.
Mean reversion says that prices may get knocked off-kilter, either by getting themselves overbought or oversold but when that happens they will tend to revert back to a mean level somewhere in the middle of two extremes.
Momentum says that prices in motion, in other words moving in a particular direction whether up or down will tend to continue in that direction.
The swing trading approaches we are looking at here are aimed at spotting price patterns that are either reverting back to a mean if prices reverse back where they came from, or are heading off continuing in the same direction under the influence of momentum.
Just for interest, another hypothesis says that market prices follow a random walk with no discernible pattern.
Support becomes resistance and resistance becomes support
If support is broken through in a downward direction, then the level that was support becomes a new level of resistance. If resistance is broken in an upward direction, then the level that was resistance becomes a new level of support.
These are two interesting statements and you may hear this or read this in many books or articles on trading and investing, and it is useful to see how this happens.
Let’s consider the point where the price has moved down and is hitting a level of support. There are a number of market players involved here deciding what to do next.
- Investors who are long in the stock
- Investors who are buying the stock at the support level
- Short-sellers who are opening short positions on the stock
- Other investors or traders who are watching the stock but have not yet taken a position
If the combined action of short-sellers and investors holding the stock who decide to sell at this level overcome the buying pressure from investors buying the stock, then the stock price will break through the support level.
What tends to happen at this point is that investors who were buying at the previous support level will have placed stop-loss sell orders that will be triggered. Investors who hold the stock may also decide to sell or may have stop-loss or trailing loss orders that get triggered. More short-sellers may also open short positions.
Investors and traders who are watching the stock may see what looks like a breakthrough and enter the market on the side of the downward trend.
For these reasons when a price support level is broken by more than a few percentage points, the price tends to continue down further.
The same happens when price resistance is broken. Short-sellers who had taken positions at or near the resistance level expecting that the price would drop from there will likely cover their short positions by buying back the stock. Traders will also enter long positions seeing that a level of resistance has been broken. So when price resistance is broken by a few percentage points, these buying pressures tend to push the price higher still.
An important thing to note is that much of this trading is being executed by computers programmed to trade at or within a few percentage points of the support and resistance levels. So there is some inevitability and momentum to these price movements.
As we noted before, what we observe is that a level that was price resistance, once broken becomes a level of support. Much of this is because traders who enter new positions place stop-loss orders very close to the levels where they entered.
In seeking to understand how the price of a stock is behaving, we draw trend lines. If a price chart shows two significant price peaks then we can draw a line that becomes a tentative trend.
If the price returns to this line and bounces off it making a third peak, then we have a confirmed trend line.
This principle of joining two significant peaks and then a third works whether the trend is up, down, or sideways. We can draw trend lines that join significant price troughs in the same way.
Trending within a range
When we have a trend line joining peaks and a trend line joining troughs that are parallel, we say that the price is ranging in a trending channel. The trending channel can be upward downward or sideways.
Trading volume is another indicator of how well support, resistance, and trend lines will hold. When you see higher volume at a level of price support that is an indicator that the support level is valid. The same holds true at a level of price resistance.
However, while it takes stronger volume to move the price up from a level of support, higher volume at a level of price resistance is less important. Prices can fall from a level of resistance without higher volume.
Trends within trends
One thing to notice if you zoom into a price chart to see shorter time frames you will see trends within trends. The same holds if you zoom out to a larger time frame. To illustrate this we can see in the chart below.
In this chart, the overall trend from A to D is up, and while A to B and C to D are up, however, B to C within A to D is a downward trend. So when defining whether a trend is up, down, or sideways it is necessary to define the time frame, whether that is minutes, hours, days, weeks, months, or years.
Trading within a range
Going back to our definition of swing trading, the idea was to trade within a range. There are different ways to trade within a trend.
An aggressive approach is to enter either a long position once a tentative level of price support has been identified and then exit that position when price resistance is reached.
A general principle is that if you are aggressive in position entry you should be aggressive in exiting positions as well. Trading within a channel that is only tentatively identified is likely to result in often being on the wrong side of the trade. So with this approach, tight stop-loss positions are well-advised. Here is an explanation about using stop-loss orders.
A less aggressive approach is to enter positions only when a trending channel is established. It is still advised to use tight stop-loss orders because of the way price tends to behave around support and resistance levels. In simple terms, if you do happen to be on the wrong side of the trade, you should find out pretty quickly in which case it is best to exit quickly with tight stop-loss orders.
With this approach, you are at a greater risk of having missed the boat, and either the level of support breaks in a downward direction or price breaks through a level of resistance in the upward direction.
Price targets beyond a range
Another approach to trading uses the size of an established trending range to set a price objective once the price breaks out of the range.
There are a number of classic price patterns each with its own price breakout and standard way to estimate where the price will go after the breakout.
Starting with the classic reversal patterns there are the head and shoulders, the inverted head and shoulders, and the triple top and triple bottom. Here is the head and shoulders pattern.
For the head and shoulders pattern, the neckline is drawn between the price lows on either side of the head. Then when the price comes down from the right shoulder and breaks through the extended neckline, the estimated price target is the distance from the peak of the head to the neckline extended below the breakout point.
The same works in reverse for the inverted head and shoulders pattern.
Because the inverted head and shoulders pattern is a prelude to a reversal of a downward trend to an upward trend, strong trading volume on the breakout is more important than for the head and shoulders.
The triple top and triple bottom are pretty much like a head and shoulders pattern with a lower head. The same principle applies to establishing estimated price targets.
Following the general principle of momentum and since it usually takes more to reverse a trend than it does to continue a trend, reversal patterns take time to develop. The longer they take and the larger they are in price terms the more probable it is that the price trend will indeed reverse.
While reversal patterns take time to develop and have an effect, and that can typically be months, price continuation patterns are more indicators that a price uptrend or downtrend is pausing and moving sideways for a while before resuming the previous trend. Continuation patterns may last a few weeks to a month while a reversal pattern often takes a few months to form.
The most common continuation patterns are triangles and wedges. There are three kinds of triangles, the symmetrical, the ascending, and the descending triangle.
The ascending triangle usually occurs on an uptrend and pauses the trend. As an ascending triangle, there is greater buying pressure pushing each successive price trough higher so it is an indicator of bullish price continuation. Similar considerations apply to a descending triangle which shows greater selling pressure push successive price peaks lower and so is an indicator of bearish price trend continuation.
A symmetrical triangle can appear in an uptrend or in a downtrend and indicates that buying and selling pressures are about equal so shows the likelihood of continuation of the previous price trend.
The principle difference between a wedge and a triangle is that a triangle is either symmetrical around a horizontal line or has one side as a horizontal line. With a wedge, however, neither side of the triangle is horizontal. A wedge has a general slant and the slant is usually counter to the direction of the trend.
So you will see a descending wedge in a price uptrend, and this is a bullish trend continuation indicator. In the same way, you will see an ascending wedge in a price downtrend and this is a bearish trend continuation indicator.
Breaking the triangle
A common feature observed with triangles is that the price breakout and continuation of the trend tend to happen around two-thirds of the way into the triangle. The point being once a triangle has run two-thirds you should expect that the pattern will be broken and the previous trend will resume.
There are different schools of thought on establishing a price target following a breakout from a triangle or a wedge. Once the triangle pattern has been broken we can expect the price to continue with the previous trend.
The conservative approach is to estimate a price target after the pattern is broken extending the same vertical distance as measured from the second price point to touch and bounce off one of the sides the vertical distance of the other side of the triangle. This is easier to see on a diagram than to explain in words.
After the price has reached the objective we can expect a correction or period of sideways movement. Either way, the price target is a good exit point. The same principle of finding a price objective can be applied to the other triangle and wedge patterns.
Head and shoulders again
A head and shoulders pattern can also appear in an uptrend. This tends to just act as a pause on the main upward price trend. A similar pattern can be seen with an inverted head and shoulders pattern in a price downtrend. Here is what these look like
Like for the reversal patterns, as continuation patterns, they can also be used to establish price targets.
Yes, there are other patterns including flags and pennants and expanding triangles and wedges. Flags and pennants are quite frequently seen and can be traded in the same way as triangles and wedges. Expanding forms are less frequently seen.
However, if you start out trying to identify all kinds of patterns out there you will not see the wood for the trees. It is better to start trying to identify a few of the most frequent and more reliable patterns and build experience and confidence trading what you can see.
In addition to defining a price target and setting a stop-loss for each trade you enter, you should set a target time by which the price should reach its target. To some extent, this is a matter of personal preference, but what you have to watch for is softening momentum.
Since we are swing trading, we are trying to catch the momentum of a price swing that is either sending the price bouncing back from a support or resistance level or catapulting from a price breakout. If we wait too long then momentum may be lost and the price could revert back to a mean.
A simple way to set a price target is to use the formation of the price pattern and extend that out. So if it took three months for a price pattern to form it would be reasonable to wait three months for the price to hit its target. I would recommend watching the daily trading volume and other indicators to be sure that there is still momentum behind your desired price move.
What this means for the swing trader
We had our earlier definition of swing trading as trading within levels of price support and resistance. I would extend that definition to trading either side of price support and resistance.
Since establishing support and resistance and trend lines is more an art than a mathematical science, it isn’t really practical to backtest this approach to trading. Price charts more often than not present confusing pictures rather than clearly formed textbook trend reversal or continuation patterns. This means it takes time and practice.
So how do you go about acquiring this skill – a good place is to start with historical price charts but I wouldn’t suggest just any old charts.
Since there are many stocks, ETFs, commodities, and forex pairs to chose from it makes sense to choose the most likely candidates, so what attributes are we looking for?
- high volume
That is a general list but I would go further. OK, this is my personal taste but I think it makes the most sense to stick with stocks and ETFs for a number of reasons.
Stocks and ETFs are building in value over time. This means if you stick with the stocks of growth companies or the ETFs of growing industries, you have a reasonable expectation of seeing value appreciation over time.
Most of the large online brokers will allow retail investors and traders to open a brokerage account with no or a very low account minimum and trade stocks and ETFs on US exchanges with no fees. This doesn’t apply to penny stocks. But if you want to invest in or trade penny stocks that is a whole other animal.
Many stocks and ETFs will also exhibit large price movements in relatively short spaces of time. Some stocks will move 5 or 10 percent in a week and you need price movement to be able to make meaningful trades.
Stocks in large companies will often be heavily traded making them liquid which means you are always going to be able to get in and out of a position.
Another important feature of stocks and ETFs is that many larger and higher value stocks and ETFs will have options that can be readily traded. As you gain experience and confidence in trading stock and ETF positions over the short and intermediate-term or a few weeks to months it is a straightforward task to trade options instead of those stocks and ETFs. If you chose options carefully you can amplify your results while managing your risks. By amplify I mean you can increase your gains and your losses.
What kinds of stocks and ETFs
So of all the thousands of available stocks and ETFs which ones should you be studying – clearly nobody can study thousands of price charts every day and stay sane.
Again this is my personal choice but I would target first leading stocks and ETFs in leading sectors. This is because you are going to have the most price movement in an upward direction with these stocks and ETFs. Here is another piece of reality, most of us starting out are going to be more comfortable taking long positions in a bull market than short-selling stocks or buying put options.
How many trades and how often
This is an important question and one of personal taste and capacity, but there is a practical consideration. To spot price patterns that can be traded you need to be studying the charts of a number of stocks and ETFs on a daily basis. It probably makes sense to start with a manageable number. I would say that studying the same 10 price charts a day is a good place to start.
We have noted before how reversal patterns take up to a few months to form and a continuation pattern a month or so. We can also conclude that levels of price support and resistance can be tentatively revealed in a month or so. Under these circumstances, we could anticipate identifying somewhere between a few to 10 trades per month. Also, because of the nature of the signals, we would be trading on, we can expect to hold each position between a week to a month or so.
Comparing the different patterns we have looked at, we can expect that the price target for a head and shoulders pattern would yield a gain of between 5 and 10 percent or a loss of 2 percent. We would typically have to hold a position following a head and shoulders signal for up to a few months.
I would also expect similar results from the other price reversal patterns and price continuation patterns we looked at.
Breakout or fake out
We should be aware that many would be price breakouts turn out to be fake outs. This is going to happen. It doesn’t necessarily mean that a trade goes bad on us and we get stopped out. It can also mean that instead of the price merrily marching off where we wanted it to go, it sort of coughs and splutters and staggers and doesn’t quite get there.
So instead of closing out a trade after a month with a 10 percent gain, we may opt to close out a trade with a 4 to 5 percent gain after a month and a half if we see uncertain and wavering price movement. Faced with such a situation it is going to be better to close the trade and move on.
Between support and resistance
Looking at the shorter-term patterns, if we are trading off price bounces from levels of support or resistance we can expect smaller gains of 3 to 5 percent and we would need to work with very tight stop-loss orders to limit losses to 1 percent or less. I would expect to hold such positions for one to a few weeks.
Mind the gap
One of the downsides of swing trading stocks and ETFs is price gaps.
Prices can move in between trading periods, i.e. days or over a weekend in jumps. In these cases, we say that prices gap up or gap down. You sometimes see price gaps of 10 percent or more and these can happen on earnings reports or other sudden news. Where these gaps can hurt a swing trader is if you are stopped out of a position at a price level substantially beyond your stop-loss order level.
If you swing trade this is going to happen. You can minimize this to some extent by avoiding holding positions over earnings reporting dates, but you can never eliminate the risk of sudden unexpected overnight news.
Slippage is the term used to account for losses on trades that happen when you open and close positions. There is always a price bid and ask spread and it is unlikely that all your trades will be executed at exactly the midpoint between the two. Your broker will be shaving off the bid and ask spreads and this will mean less gain and more loss than you fully anticipated. The more you trade and the narrower profits you trade for the greater will be the impact of slippage on your overall trading gains.
One thing many professional investors and traders will advise is to paper trade for some time before you start with real money. I think this is much a question of temperament. If you have the temperament to trade on paper for six months or so then please do. You will learn a lot.
The reality is though that trading only becomes real when you have skin in the game – i.e. your own money. Much will depend on your circumstances, but it is possible to start trading with just a few hundred dollars and while you are learning there is no need to compound your gains. You can start with a position size of 100 or even as low as 50 dollars and trade fractional shares and stick with that level until you are comfortable to increase your position size.
Questions and answers
Q. What is the difference between swing trading and day trading?
A. Swing trading involves holding positions for a few days to months. Day-trading involves opening and closing positions within a single trading day. You need real-time price data today trade however you can work with time-delayed prices for swing trading. Day trading will keep you glued to your screen when the market is open but swing trading can be done part-time. Many swing traders have regular day jobs.
Q. Is swing trading more profitable than day trading?
A. Both swing trading and day trading can be profitable and you can lose your shirt doing either. Many people try swing trading and do not succeed because they don’t take the time or effort to study and learn and develop a working trading system. Day trading usually takes more preparation than swing trading because you will need to pay for real-time price data, but you can also easily fail at day trading since the profit margins are narrower and commissions and price slippage will play a bigger role than they do in swing trading.
Q. How much money can you make swing trading?
A. You will see a lot of divergence of opinion on the answer to this question. Some will conservatively tell you that a trader can expect to earn around 10 percent a year on their capital. Others will tell you that between 10 and 40 percent is more reasonable and some years may also be down years, i.e. you may lose.
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