[Michael C. Thomsett] Getting Started in Swing Tra

Getting Started in

SWINGTRADING

Michael C. Thomsett

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Getting Started in

SWINGTRADING

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The Getting Started In Series

Getting Started in Online Day Trading by Kassandra BentleyGetting Started in Asset Allocation by Bill Bresnan and Eric P. GelbGetting Started in Online Investing by David L. Brown

and Kassandra BentleyGetting Started in Investment Clubs by Marsha BertrandGetting Started in Stocks by Alvin D. HallGetting Started in Mutual Funds by Alvin D. HallGetting Started in Estate Planning by Kerry HannonGetting Started in 401(k) Investing by Paul KatzeffGetting Started in Internet Investing by Paul KatzeffGetting Started in Security Analysis by Peter J. KleinGetting Started in Global Investing by Robert P. KreitlerGetting Started in Futures by Todd LoftonGetting Started in Financial Information by Daniel Moreau

and Tracey LongoGetting Started in Technical Analysis by Jack D. SchwagerGetting Started in Hedge Funds by Daniel A. StrachmanGetting Started in Rental Income by Michael C. ThomsettGetting Started in Property Flipping by Michael C. ThomsettGetting Started in Fundamental Analysis by Michael C. ThomsettGetting Started in Six Sigma by Michael C. ThomsettGetting Started in Options by Michael C. ThomsettGetting Started in Real Estate Investing by Michael C. Thomsett

and Jean Freestone ThomsettGetting Started in Annuities by Gordon M. WilliamsonGetting Started in Bonds by Sharon Saltzgiver Wright

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Getting Started in

SWINGTRADING

Michael C. Thomsett

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Copyright 2007 by Michael C. Thomsett. All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey.

Published simultaneously in Canada.

No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or byany means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted un-der Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permissionof the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clear-ance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, (978) 750-8400, fax (978) 646-8600, or onthe web at www.copyright.com. Requests to the Publisher for permission should be addressed to the Permis-sions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, (201) 748-6011, fax(201) 748-6008, or online at http://www.wiley.com/go/permissions.

Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts inpreparing this book, they make no representations or warranties with respect to the accuracy or completenessof the contents of this book and specifically disclaim any implied warranties of merchantability or fitness fora particular purpose. No warranty may be created or extended by sales representatives or written sales materi-als. The advice and strategies contained herein may not be suitable for your situation. You should consultwith a professional where appropriate. Neither the publisher nor author shall be liable for any loss of profitor any other commercial damages, including but not limited to special, incidental, consequential, or otherdamages.

For general information on our other products and services or for technical support, please contact our Customer Care Department within the United States at (800) 762-2974, outside the United States at (317)572-3993 or fax (317) 572-4002.

Wiley also publishes its books in a variety of electronic formats. Some content that appears in print may not be available in electronic books. For more information about Wiley products, visit our website atwww.wiley.com.

Library of Congress Cataloging-in-Publication Data:

Thomsett, Michael C.Getting started in swing trading / Michael C. Thomsett.

p. cm.Includes index.ISBN-13: 978-0-470-08461-8 (pbk.)ISBN-10: 0-470-08461-8 (pbk.)1. Investment analysis. 2. Stocks. 3. SpeculationPsychological aspects. I. Title. HG4529.T488 2007332.632042dc22

2006033462

Printed in the United States of America.

10 9 8 7 6 5 4 3 2 1

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CONTENTS

Introduction: Why Swing Trading Makes Sense Today vii

Chapter 1The Big Picture: How Swing Trading Works 1

Chapter 2The Basic Technical Rules 23

Chapter 3Candlestick Charting for Swing Trading 45

Chapter 4Reaction Swings and the Reaction Cycle 65

Chapter 5Brokerage Rules and the Pattern Day Trader 87

Chapter 6Picking Stocks for Swing Trading 103

Chapter 7Selling Short: Entering a Swing Trade with a Short Order 125

Chapter 8Options for Swing Trading: the Basics 135

v

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CONTENTSvi

Chapter 9Option Strategies for Swing Trading 159

Chapter 10Swing Trading in Your Investment Portfolio 179

Glossary 197

Index 209

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vii

Introduction

Why Swing TradingMakes Sense Today

Swing trading is not a new idea. It has only recently become a viablestrategy for the average investor. Before the Internet opened upmarkets to virtually everyone, only the select few with access to an

exchange trading floor could make short-term trades in and out of posi-tions on a daily basis.

In that pre-Internet era, real-time quotes or online charting servicessimply did not exist. To get a quote on a stock, you would have to tele-phone a stockbroker, leave a message, and hope your call was returnedbefore the market closed. It was impossible to track stock prices through-out the day because, again, you needed the stockbroker who had exclu-sive access to price information. So swing tradingmovement in and outof positions to take advantage of short-term price movementswas justnot possible.

In the 1980s stockbrokers began relying on a primitive version ofautomated access to exchange floors. An old system, Quotron, providedbrokers with desktop PCs to get quotes in much faster time than ever be-fore. This was revolutionary. Those brokers with Quotron machines hada distinct advantage over those brokers who depended on delayed quotesand telephone or ticker-based quotes on exchange floors.

Even the revolution of providing stockbrokers with their own directaccess, pales in comparison to todays environment. Stockbrokers are, es-sentially, obsolete. Any trader who knows enough about investing andwho knows how to execute a trade is likely to use an online discount bro-

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INTRODUCT IONviii

kerage service, which is so incredibly easy that traditional brokerage ser-vices are of questionable value. The traditional firms have emphasizedthe need for professional advice from their analysts, but the trackrecord is dismal. Not only have analysts recommendations under-performed the market; in some cases, investors would have done betterto do the exact opposite of the suggestions offered to them.

Today, the old-style stockbroker has quietly faded away to be re-placed with the combination of analysts and subscription services. Theclaim that these services provide some kind of valuable information isdubious. In fact, investors now get superior free information from onlinebrokerage services and do not need to pay for help. For example, themost successful discount brokerage firm, Charles Schwab, provides itstraders with free access to Standard & Poors Stock Reports, Reuters Re-search Ratings, and Schwabs own Equity Rating service all for thousandsof publicly listed companies.

Informed investorsthose most likely to be attracted to short-termstrategies such as swing tradingare the least likely to depend on advicefrom others. Historically, advice from stockbrokers, financial advisorsand analysts has been very poor, and todays individual investor is morelikely than ever before to want to proceed without help or advice from acommission-based or subscription-based person or company.

This book is addressed to the investor who recognizes the limita-tions of depending on others for investment advice; who is willing tolearn the essential steps needed to invest on his or her own; and whowants to master proven strategies.

No one can show you how to get rich quick and with no risk. Thosekinds of promises are vacant and unfounded. But it is possible to increaseyour rate of successes by utilizing strategies that give you an edge andhelp to anticipate the next price direction. There is no sure-fire methodto achieving 100 percent profits. But swing trading can improve yourrate of success, your timing, and your overall profitability.

This book also answers the question of what products to use inswing trading. Most people simply assume that you must use stocks totake long or short positions in stocks as part of a swing trading strategy.This topic is covered in depth. Realistically, however, buying and sellingshares of stocks is a limited strategy because you are restricted to invest-ing by a limited pool of capital. Later in this book, you will discover waysto expand your swing trading potential with less money and lower risk.You will also see how to take up positions when you expect stock to trend

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downward but without having to sell stock short. This high-risk strategyis not the only way, or even the best or most affordable way, to play abear market.

So while you learn about swing trading, you will also expand yourunderstanding of market risk, gaining insight into alternative ways to in-vest, and improving your knowledge base in the market. Swing trading isa short-term technical strategy. That does not mean it has to be high-riskor appropriate only for the most experienced or wealthiest investors. It isa strategy that can be useful to anyone as long as the basic realities of risk,timing, and methods of investing are mastered and observed.

I n troduct ion ix

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11The Big Picture

How Swing Trading Works

Everyone knows that big institutional investors such as mutual fundshave a tremendous advantage over the individual investormoremoney, better research, broad diversification. In some respects,

however, you have an advantage over the big institutions. They cannotmake decisions quickly in the market; pay attention to the subtle, short-term price gyrations that characterize market cycles; or watch only a fewkey stocks. The big institutions have to take a shotgun approach to in-vesting, just because of their size.

You probably dont have millions of dollars inyour portfolio and you dont have to answer to any-one else. This flexibility and mobility is your ad-vantage; and this is where you can benefit fromswing trading strategies. With swing trading, youoperate within a very limited window, two to fivedays worth of activity in most cases.

You will observe that stock price movement inthe short term tends to react (or more specifically,to overreact) to each and every market event. Thisrange of events includes trading volume, broadermarket activity, and all financial, economic and po-litical news. Later in this chapter, this tendency of

Chapter

swing trading

a strategy thatinvolves two- tofive-day marketcycles and identi-fies high and lowpoints in short-term cycles; andflags key pointsfor moving in andout of stock posi-tions based onspecific chartpattern signals.

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stock prices is explained in the context of the threedominant emotions that literally rule the market:greed, fear and uncertainty.

Short-term price movement can be definedand anticipated in terms of these three emotions,and this is where you gain your swing trading ad-vantage. Rather than making decisions based ofgreed, fear and uncertainty, swing trading is a tech-nique based on logic and analysis rather than onemotion. An old adage about the market statesthat bull and bears can make profits, but pigs andchickens cannot. This is entirely true. You canmake profits in all types of markets, but only if youare able to see past the emotional reactions thatgovern the thinking of the majority.

In fact, those emotions largely determine andcause those short-term price changes in the market.The fact that short-term pricing is chaotic dis-proves the efficient market hypothesis, the belief thatall pricing of stocks reflects everything that is pub-licly known at any given time. The reality provesthat this is untrue.

The efficient market might exist on a differentlevel. For example, the long-term averages of pricemovement may occur on some level of efficiency,but the two- to five-day movement of price is virtu-ally caused completely by those three troublingemotions and their domination of market thinking.

So it is reasonable to believe that the efficientmarket hypothesis might be a valid theory over thelong-term, but not in the short-term. The opposite

is true of another market concept, the random walk theory. This is a morefatalistic view of the market. The random walk is a belief that at anygiven time, there is a 50/50 chance that a stocks price will rise or fall.The whole pricing of stocks is believed to be completely random.

The random walk accurately describes the two- to five-day tendencyof stocks. Short-term pricing is obviously responsive to emotional over-reaction and illogic. However, over the long term, an analysis of stock pricing

efficientmarkethypothesis

the theory thatpricing of stocksreflects all infor-mation currentlyknown byinvestors at anygiven time, result-ing in the conclu-sion that all stockprices are fair and reasonable.

random walktheory

a belief that allpricing of stocksis random, andthat at any timethere is a 50/50chance that astocks price willeither rise or fall.This theory dis-counts the valueof fundamentalanalysis and as-sumes that stockpricing is a battlebetween buyersand sellers forpurely technicalreasons.

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demonstrates a clear connection between strong fundamentals and strongprice growth (or, on the other hand, weak fundamentals leading to pricedeterioration). So the two major theories can be quite instructive in under-standing both short-term and long-term stock pricing:

1. The efficient market hypothesis makes sense but only over thelong term. For the short-term pricing of stocks, there is no appar-ent efficiency involved; stock pricing changes due to emotionaleffects.

2. The random walk theory makes perfect sense in the two- to five-day window and perfectly describes the way that stocks behave.However, it is not so much a random event, but the outcome of astruggle between the greed and fear of investors (with uncertaintyrepresenting a stalemate between the two). However, over thelong term, the random walk theory falls apart.

An Overview: The Basic Definitions

Any approach you take in the market will determine your success, ofcourse. But there is a tendency among investors to believe that some sys-tems are effective in ensuring consistent profits, and this is simply nottrue. Timing is the key to profits. While picking fundamentally strongstocks is essential, of course, it is timing more than anything else that de-termines whether your decisions create profits or losses.

Most people who buy shares of stock automatically assume that theprice they pay is a starting point or the zero base of their investment.From that zero base price the stock is supposed to rise. But as everyonewho has put money into stocks already knows, the stocks price some-times falls.

An Overv iew: The Bas ic De f in i t ions 3

Swing traders observe how emotions affect price, and act whenthose emotions exaggerate a trend to present a profit opportunity.

Key Point

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THE B IG P ICTURE4

The system you employ to pick stocks mayserve as your real starting point; the strategy youemploy controls the timing for putting your strat-egy into place. This is the primary difference. Itdoes not matter whether you are a believer in fun-damental analysis or technical analysis. The rule re-mains the same: the method is used to isolate thosestocks you want to trade, and the strategy controlsthe timing of your decision. Swing trading providesyou with one effective strategy.

Swing traders use the timing of short-termtrading patterns to take advantage of the tendenciesof stock prices. These tendencies are to trade inbrief waves (thus, the importance of the two- tofive-day time span) in which stock prices rise andfall. After specific patterns and signals occur, a re-versal often takes place and this is where swingtrading becomes a powerful timing strategy.

The swing trader recognizes these patterns.After a stocks price has risen in a specific pattern(in the movement of the price, the price distance ina days trading range, and the volume), the swingtrader recognizes a sell signal. After the price falls ina specific pattern, the swing trader moves in andbuys. This timing goes in opposition to the most

recent price pattern, and is aimed at anticipating a reversal. The naturaltendency for pricing is to operate in these short-term back-and-forth cy-cles. Because swing trading involves timing a trade in anticipation thatprices are going to go the opposite, way, swing trading is a short-termform of contrarian investing.

Everyone tends to believe that their purchase price is the start-ing point in a stocks price. Realistically, though, it might bemidway through a trend or at the trends very peak.

Key Point

fundamentalanalysis

the valuation ofstocks based on acompanys finan-cial strength,earnings, andtrends, includingassessment ofworking capital,equity and debtcapitalization,and operatingresults.

technicalanalysis

the study of stockprice and volumetrends, charts,and trading pat-terns, for thepurpose of antici-pating short-termprice movementto time trades.

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Typically, traders tend to be reactive ratherthan contrarian. So when people see a stock mov-ing up, they want to buy; and when they see itmoving down, they want to sell. Swing traders, incomparison, are faithful to the best-known marketadvice: Buy low and sell high. The unfortunate truthis that the majority of investors do exactly the op-posite. They buy when prices have moved higherout of greed, and they sell when prices fall, out offear. Swing trading is a strategy for short-term trad-ing that puts the concept of buy low and sell highinto effect.

Contrarian investing in practice is far morecomplex than the timing of trades. The contrarianinterprets both fundamental and technical signalsin ways dissimilar to the common thinking seen in the market. Timing isonly one aspect to the contrarian point of view; but for swing traders it isa critical point.

The struggle between crowd mentality of the market and the con-trarian view extends as well to philosophies about which kind of data toemploy for decisions. The fundamental view (adherence to recent histor-ical financial results as the basis for making trades) and the technical view(based on price movement and patterns to anticipate the next move orseries of moves) are not always at odds. Although swing trading is apurely technical strategy, it can be employed in a manner that combinesboth fundamental and technical indicators. The distinction should bekept clear: picking specific stocks is not the same as timing buy and selldecisions. With that in mind, you may consider using the fundamentalsto pick a range of stocks you want to trade; and then use swing tradingand other technical tools to actually time your decisions.

An Overv iew: The Bas ic De f in i t ions 5

contrarianinvesting

an approach toinvesting basedon the assump-tion that the ma-jority is moreoften wrong thanright in its buyand sell decisions,and that timingwill be improvedby taking actionsopposite the mar-ket as a whole.

When investors respond to greed and fear, they tend to buy highand sell how. Swing traders are able to respond unemotionally,and achieve the opposite: Buy low and sell high.

Key Point

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THE B IG P ICTURE6

Too often, investors are asked to choose between fundamental andtechnical schools of thought. It makes more sense to use both. Both ap-proaches may limit your view of what is occurring in the market; andboth sides contain flows. Fundamentals are strictly historical and may beoutdated by the time you need to make a decision. Technical indicatorsare invariably short-term in nature and short-term indicators are histori-cally unreliable for long-term investing.

The lesson to learn from this is that both fundamental and techni-cal sides are going to contain flaws, but both contain useful aspects. Ei-ther theory should be dependent on a study of trends, both short-termand long-term. The trend is the key to picking stocks and to timing buyand sell decisions.

Swing Trading, Day Trading, and Long-TermHold Strategies

There are many ways to invest in the market. Themost conservative investors want low volatility andslow but steady growth; speculators welcomevolatile stocks and the unsure future because suchstocks exhibit broader price swings. A speculatorwelcomes higher risk in recognition of the in-escapable relationship between risk and profit.With few exceptions, risk and profit are two sidesof the same market coin.

The most conservative position within themarket is selection of a company perceived to besafe. This normally means that capitalization ishigh; the company has been in business for manydecades; and the company dominates its sector.Such companies have grown over the long term butonly slowly and steadily. The conservative long-term hold is far from exciting, but it does create asolid, safe base for your portfolio.

On the opposite side of the risk spectrum is thehighly speculative approach. People in this part of themarket buy penny stocks, IPOs, and highly-volatileissues; trade options to achieve leverage; and may even

speculators

individuals willingto take greaterthan average risksin exchange forthe opportunityfor higher thanaverage profits.

long-termhold

description of astrategy for port-folio manage-ment, involvingselection ofstocks with theintention of hold-ing shares formany years inorder to build asecure base forlong-term growth.

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combine high-risk stock trades with index investments, commodities trad-ing, and stock futures. These are very exotic forms of risk, and only thosewho thoroughly understand the market and the risks themselves should beinvolved. To a degree, swing traders may want to em-ploy options as part of their strategy (this is exploredin later chapters). But options can be employed in rel-atively safe ways to leverage money without exposingyourself to the possibility of huge losses. That is thedistinction between a swing traders use of instru-ments like options, versus pure speculation. A specula-tor intentionally exposes capital to the risk of loss, buta swing trader uses options to limit losses and to lever-age capital.

Somewhere in between these extremes is theday trader. This is a trader who intentionally movescapital in and out of stock positions in the extremeshort-term, usually within a single trading day. Daytraders are also usually high-volume traders, execut-ing numerous daily trades in more than one stock; ormany trades in the same stock. If an individual buysand sells the same stock on very high volume (fourtimes or more within five consecutive days), they areclassified as a pattern day trader by the Securities andExchange Commission (SEC) and are subject to spe-cial rules for cash held in a trading account.

The swing trader is likely to belong closer tothe side of the speculator than that of the conserva-tive investor. This does not mean that swing trad-ing is necessarily high-risk in comparison to otherstrategies. You can limit your capital exposure to

Swing Trad ing , Day Trad ing , and Long-Term Ho ld Strateg ies 7

Conservative investing is safer than high-risk; but it also offersfar lower opportunities for profit. The elements of risk andprofit are directly related and cannot be separated.

Key Point

day trader

an individual whoexecutes tradeswithin a singleday or over theshortest possibletime, often mov-ing in and out ofpositions within amatter of hoursand employing ahigh volume oftrading activity.

pattern daytrader

as defined by theSEC, any traderwho buys or sellsa single stockfour or moretimes within fivedays; a patternday trader mustmaintain no lessthan $25,000account equitybefore a highvolume of tradingis permitted.

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swing trading, your volume of trades, and the number of stocks youswing tradeall to reduce overall risk or to limit your exposure. But inthe spectrum of investing, everyone should be able to identify where aspecific strategy belongs.

Any strategy may also be used in combination with other strategieswith dissimilar risk characteristics. Diversifying by risk is a wise and ef-fective way to manage your portfolio. For example, you may have themajority of your capital invested in your own home, certificates of de-posit, and Blue Chip stocks; and use a relatively small portion of yourcapital for swing trading and other strategies.

The Swing Trade Approach: The Strategy in a Nutshell

The precise method of swing trading is going to vary among individuals.Everyone has their favorite variation on any strategy. If you have ob-served how people behave in the market, you also know that investors areat times ingenious, at other times irrational, emotional, or unrealisticallyhopeful. The what if factor is always present.

Swing trading is a process of fixing a series of rules that trigger atrade decision. It is based on the study of stock price patterns over a shortperiod of time, the two- to five-day window. Because swing traders rec-ognize that short-term price swings reflect investor emotions, they tradein a unique manner. Rather than trading the stock, swing traders timetheir decisions to trade the emotions that dominate the market. Thisdoes not mean that the stocks fundamentals are unimportant. In fact, astarting point should be to narrow a list of stocks you will swing trade,based on both fundamental and technical analysis. These may be at con-flict to a degree. The purpose of using the fundamentals is not to find thesafest stocks because these will not be good candidates for swing trading.

The market is characterized by prevailing myths. The beliefs ofmany investors and traders are provably irrational in manycases, but continue to be widely believed. For example, therereally is no system for creating 100% profits.

Key Point

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The ideal stock is one with strong fundamentals (excellent manage-ment, long-term growth history, etc.) but with short-term volatile tech-nical signals. This means, of course, that the trading range (the distancebetween typical high and low prices) is broader than the average stocks.

So swing traders need well managed companies whose stocks aresomewhat volatile. This is a middle ground; many well managed compa-nies experience short-term volatility because they are in the news; earn-ings are uncertain; or product news may cause the stock to rise or fall, orto do both in turn. So if you must define the ideal stock for swing trad-ing, it would be one with strong long-term fundamentals and veryvolatile short-term technical signals.

The majority of investors are not well informed; and this is whereyou have the advantage as a swing trader. In the environment wheregreed and fear dominate decision-making, you are matched up againstpeople who will be willing to buy stock from you at too high a price; orwho will sell stock to you at a bargain price. You recognize these tenden-cies by tracking the daily chart patterns and identifying the turningpoints and reacting to the reversal signals you find through swing trad-ing. As a swing trader, you benefit from the way that most people makedecisionsimpulsively, emotionally, and at the wrong time.

Most people buy when they should sell and sell when they shouldbuy. Swing trading may be thought of a technique for trading emotions(or even trading people and their tendency to react with the emotions ofgreed and fear). In some respects, this means that it doesnt really matterwhich stocks you trade, because the technique applies to all stocks and toall short-term price trends. But because stocks are different, it remains awise idea to identify a range of stocks by attribute that are best suited for(a) short-term swing trading based on an appropriate volatility level and(b) long-term safety based on strong fundamentals. This is sound advicebecause some swing traders decide to hold onto their stocks even when

The Swing Trade Approach : The Strategy in a Nutshe l l 9

It makes sense to be flexible. You might start out swing tradingonly to realize that a stock is a solid long-term hold. In thatcase, buying the stock makes sense ... and does not prevent youfrom continuing to swing trade in the stock as well.

Key Point

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THE B IG P ICTURE10

the original plan was to swing trade. If you are going to end up keepingsome of the stock you buy, it should be high-quality stock from a long-term perspective.

Using the swing trading technique, you identify some very specificshort-term trends. While day traders watch price movement moment tomoment, swing traders normally base their timing decisions on end-of-day chart patterns. The two-to five-day window is based on the theorythat a days trends are revealing. This means that the opening and closingprice, the trading range and the breadth of that range (distance from topto bottom price) are all important in executing a swing trade. For exam-ple, one day might have an opening and closing price close to the dayshighest and lowest price levels; and another day might have very littlegap between opening and closing price, but demonstrate a lot of actionin between, with prices moving far above and below the actual open andclose price levels.

A swing is a change in direction. So a stockthat has been trending upward will swing to thedownward, and vice versa. A swing trader uses thecharting techniques involving open, close, andtrading range to recognize when such swings aremost likely to occur. Daily volume is also signifi-cant in the mix of signals that you will come to de-pend on in developing your swing trading strategy.

Within this short-term daily trend watching,the direction of each days price movement is alsoimportant. By definition, a swing is most likely tooccur when the open and close of the stock hasbeen occurring in the same direction. This meansthat in an existing uptrend, the days close shouldbe higher than the open for at least three consecu-tive days before the trend can be relied upon to puta trade into action. And when the price trend isdownward, by definition, a downtrend requires thatfor at least three days in a row, the closing price waslower than the opening price. So the overall pricerange of a days history is not enough; the directionof price movement must confirm the apparenttrend as well.

uptrend

a movement in astocks price tothe upside; forswing traders, anuptrend is definedas three or moreconsecutive daysin which the clos-ing price washigher than theopening price.

downtrend

a movement in astocks price tothe downside; forswing traders, adowntrend isdefined as threeor more consecu-tive days in whichthe closing pricewas lower thanthe opening price.

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The uptrend and downtrend used by swingtraders are not the same as the more universally rec-ognized market trends. Technicians track trends instocks as well as various indices and these are wellknown. They also use moving averages of variousconfigurations to signal or anticipate major uptrendsand downtrends. The short-term trends describedabove and used in swing trading are entirely different.

This explains as well why swing traders usu-ally stick to the complete trend of a single tradingday. When you first consider this guideline, it doesnot appear to make sense. A valid question may be, Shouldnt the deci-sion be made when trading patterns are met rather than at the end of atrading day? The answer, of course, is that any strategy should be as flex-ible as you need it to be. There is no hard-and-fast requirement that trad-ing occur only when a days trading has been completed. However, swingtraders have discovered that while their timing of trades may be flexible,the complete day is most revealing. Patterns emerge during a trading daybased on the time of day and overall direction of the market. Many tech-nicians, for example, give great importance to trends established in thefirst hour, or the first two hours. A specific stocks final hours of tradingmay be largely influenced by overall market trends on the day.

In order to establish the trend for purposes of swing trading, the fullday is considered the template and also makes comparisons uniform.This is always useful in any type of price analysis. In addition, anotherimportant type of signal may be found between the close of one day andthe open of the next day. Swing traders, like many other technicians, arelikely to assign importance when price changes between the two days


price range

the overall rangeof a stocks pricewithin a singleday, from highestprice attaineddown to lowestprice, and distinctfrom opening andclosing prices.

There is a distinct difference between traditional market pri-mary and secondary trends on the one hand, and very short-tern price trends on the other. Swing traders limit their analysisto a two- to five-day window.

Key Point

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THE B IG P ICTURE12

show large gaps, or when a low-volume day is followed by a high-volumeday. These are examples of the kind of changes occurring between daysthat will be viewed as important to swing traders, and it further supportsthe belief that to establish the two- to five-day window to identify aswing trading opportunity, you need to have the complete day and notjust hour-to-hour change. A day trader is inclined toward recognizingand grabbing profitable opportunities as they occur, but day trading is afar less sophisticated market strategy than swing trading. So while sometraders may prefer the excitement of continually watching a stocks priceduring the day, swing traders employ a more methodical system.

Chapters 3 and 4 provide you with a far more detailed explanationof the exact signals and methods of finding them. The purpose here is toprovide you with an overview of how swing trading works and how youcan use short-term trends to zero in on profit opportunities.

The basic swing trading rule is to act after three or more consistentsignals occur. When the price has been moving to the upside, the signalis to sell; and when price has been moving to the downside, the signal isto buy. Remember, the swing is the key. The theory of swing trading isbased on the belief that short-term price change occurs in predictablerhythms and cycles. Upward movement is followed by downward move-ment in these short-term trends, and vice versa.

There are several attributes required in order for these rules ofswing trading to go into effect. These are:

1. Recognize an uptrend. A true two-to five-day trend consists of aspecific pattern in opening and closing prices. In an uptrend,each day should exhibit a series of higher highs, offset by a seriesof higher lows. So each days price passes the previous days peakon the upside; and each drop is less than the previous day. Figure1.1 illustrates this principle on a simplified line graph; note thatthe trend lines for both high and low price levels conforms to theuptrend rule.

2. Recognize a downtrend. The downtrend also develops over a two-to five-day period. But it is characterized by a series of lower highsand lower lows. So each days high will be lower than the previousday; and each days low is lower than the previous day. The swingtrading downtrend is shown in Figure 1.2. This figure shows theswing trading downtrend; the high prices are progressively lowereach day, and the offsetting low prices are lower as well.

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26252423222120191817161514

Pric

e

1 2 3Day

H i g

h s

L o w s

FIGURE 1.1 The Uptrend

26252423222120191817161514

Pric

e

1 2 3Day

H i g h s

L o w s

FIGURE 1.2 The Downtrend

Swing trading is so called because of the tendency for price toswing back and forth in a two- to five-day window. This occursbecause day-to-day trading is dominated by emotion.

Key Point

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THE B IG P ICTURE14

3. Identify a setup. The setup is a signal that it istime to take action. The setup at the top of thetwo-to five-day uptrend is a sell signal. And thesetup at the end of a two- to five-day downtrendis a buy signal. In other words, the swing tradeis premised on the idea that these specific sig-nals can be used to time decisions and to profitfrom the cyclical swings in price.

4. Look for the narrow range day. All signals arestronger when they are confirmed. The narrowrange day is a day in which the distance fromhigh to low price is much smaller than preced-ing typical trading ranges. For example, if astock has been trading in a range of two to threepoints and the two- to five-day trend is estab-lished, a narrow range day at the end of the es-tablished trend is a strong confirming signal.

Remember that the narrow range day pattern isimportant only after a substantial price move. Atypical narrow range day at the end of a down-trend is a strong buy signal. This is illustrated inFigure 1.3.

setup

a signal to act in aswing trade pat-tern; the setup atthe top of anuptrend is a sellsignal, the setupat the bottom of adowntrend is abuy signal.

narrow rangeday

a day in which thehigh-to-low priceof a day is muchsmaller than thetypical day, andwhen it occursafter three or moreestablished trendday patterns.

TypicalTrading Days

NarrowRange Day

High

Close

Low

FIGURE 1.3 Typical Trading Days and Narrow Range Day

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5. Keep an eye on changes in volume. Stocks tend to trade with typi-cal daily volume, but when that level changes it often signals achange in the interaction between buyers and sellers. For swingtrading, an exceptionally high-volume day accompanied by a nar-row range day is a strong signal to act. So when the breadth oftrading narrows and volume increases substantially, that signalsthat the established trend is probably on the verge of reversing.

These signals should be used in conjunctionwith one another. When a two-to five-day uptrendhas been established, look for the setup. Confirma-tion is a very important concept in swing trading:when you are able to confirm the trend with asetup, you have an exceptionally strong buy or sellsignal. The confirming indicators are a narrowrange day and increased trading volume. When yousee both of these together, you have exceptionallystrong confirmation that it is time to act (to sell af-ter the uptrend or to buy after the downtrend).

The Theory of Chart-Watching

There are two general schools of thought about how to pick stocks andtime buy and sell decisions. The fundamental school relies on financialreports and trends and the technical school of thought bases these deci-sions on price.

The Theory o f Chart -Watch ing 15

confirmation

a signal that provides addi-tional indicationto another signal,that reinforces theindicated timingof a buy or sellmove.

No single indicator should be used alone for timing trades. Theprinciple of confirmation makes sense and is a valuable way tocombine different types of information to time your trades.

Key Point

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THE B IG P ICTURE16

While both points of view have merit, itmakes sense to use not one or the other, but both intandem. Swing trading is a technical strategy, butthe stocks you pick to use for swing trading may beselected based on fundamental strength. To the ex-tent that you are going to rely on technical signals,you will use charts as a primary timing tool. In-vestors use many different kinds of charts, the mostpopular being the OHLC chart. This consists of avertical line extending from the high to low pricefor a day; and two horizontal tabs. The one appear-ing to the left is the days opening price, and the oneto the right is the days closing price. This type ofcharting tool is illustrated in Figure 1-4.

The OHLC chart is popular because usingonly three lines, it conveys the essential informa-tion about activity over a period of time. This is ef-ficient. A more obscure chart is the point- and-figurechart. This consists of stacks of Xs and Os withoutany regard for the time involved. The Xs are shownwhen the price rose, and the Os when the price fell.This chart gives technicians a quick view of tradingrange trends, but for most investors it is not as easyto use as the OHLC chart.

Time is usually important to traders in orderto make sound judgments for their stock decisions;for this reason, the point and figure chart providesa particular kind of information for some purposes,but is not as valuable as the OHLC. Todays chart-ing services invariably include a moving average as

There is no reason to shun one type of analysis and favor theother. You can gain valuable insight from both fundamental andtechnical analysis.

Key Point

OHLC chart

a type of stockchart summariz-ing the open,high, low, andclose for a dayusing a singlevertical line andtwo horizontaltabs. The top ofthe vertical line isthe line and thebottom is the low;the left tab is thedays openingprice and the righttab is the daysclosing price.

point-and-figure chart

a stock chartreflecting risingprices withcolumns of Xsextending fromhigh to low price;and columns ofstacks Xs. Thischart does notdistinguish trad-ing days, onlytrends.

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well as daily changes in the stocks price. In addi-tion to showing the important open, high, low andclose price points, charts also include one or moremoving average lines. The most popular are 200-day and 50-day moving averages. These do awaywith the distractions of short-term volatility andshow how a stocks price has evolved over time.

A final type of chart, and one used in comingchapters in this book, is the candlestick chart. Thisdescriptive term is given because each days tradinghas a body that is either white or black, with verti-cal lines extending above and below the main body.This type of chart was developed in 18th CenturyJapan to track rice prices. In the 20th Century, U.S.technical analysts and chartists began to recognizethe value of candlesticks for tracking the OHLC but also to get an imme-diate picture of whether a trend is moving upward or downward. Chap-ter three explains candlesticks in detail.


6462605856545250484644424038363432302826

Price

10 11 12 13 14 15 18 19 20 21 22 25 26 28

Open

Close

High

Low

DayFIGURE 1.4 The OHLC Chart

moving average

a statisticalmethod of show-ing a trend that isrepresentative ofchanges withoutshort-term volatil-ity. The average iscomputed byadding up thefields in the pe-riod, and thendividing by thenumber of tradingdays.

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THE B IG P ICTURE18

Charts all summarize the flow and pattern to a stocks price cycles,both short-term and long-term. There is a natural rhythm to price trendsthat reflects the interaction between buyers and sellers and the domi-nance of one of the three market emotions: greed, fear and uncertainty.

Technicians may consider themselves to be chartists, people whorely on specific price patterns to predict the next direction of a stocksprice. Chapter two explores the many popular charting signals and ex-plains how to recognize them. The chartist tends to believe that funda-

mental analysis has limited value because it ishistorical and does not affect the forces of supplyand demand that determine price movement.Some chartists acknowledge that long-term trendsare dominated by fundamental strength or weak-ness of a company, but rely on chart price patternsfor the short term.

There are both pro and con arguments con-cerning taking the chartists approach. On the posi-tive side, the pattern of price movement doescontain a specific predictability. This is not thesame as a guarantee, but there is a tendency forprice to move in a pattern. Swing trading is a typi-

cal charting strategy because it is designed to observe and predict pricemovement. When prices move in one direction and in specific ways forthree or more trading days, the tendency is for price to then reverse andgo in the opposite direction. Because you cannot know how many peri-ods a trend involves, swing traders look for reversal signals in order totime their decisions.

Charts display the short-term tendency of prices to swing backand forth. These trends are not erratic or random; they reflect vi-sually the dominate market forces of greed, fear and uncertainty.

Key Point

chartists

technical analystswho rely primarilyon recognition ofspecific pricepatterns andshort-term trendsto predict andanticipate thenext price direc-tion in a stocksprice.

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Chartists believe that buyers and sellers continually interact. Whena stocks price rises far enough, current owners want to sell to take profits;and that causes the price to fall. When price falls far enough, the stockbecomes a bargain so new buyers place orders. The outcome of thisnever-ending interaction is the two- to five-day wave action of stocks.

On the negative side, charting is focused only on price and volumeand those who track price movement may ignore fundamental news.This is a mistake. For example, in spite of how a stocks price patternsevolve, when a company misses a deadline for filing a financial reportthat is a danger signal. For example, in October 2005 Krispy Kreme (thedoughnut chain) stock fell below $6 per share and the stock chart mayhave looked to some chartists like a buying opportunity. But somethingmore profound was going on. The company had missed its filing dead-line with the SEC and it was disclosed that improper accounting prac-tices had been in place for several years. The companys stock recoveredsomewhat by late 2006 but continued to report quarterly losses. In thissituationwhere profound fundamental problems were evidentrelyingstrictly on chart patterns would have been a mistake.

Chartists do better when they combine fundamental and technicalsignals. You may use charts as a primary timing mechanism for short-term swing trading; but selection of stocks for this play should be madebased on at least a preliminary review of fundamental issues:

Is the company solvent?

Has a profit been reported (recently or, more significantly, ever)?

How much debt is the company carrying?

Does the company compete well within its industry sector?


No investment decisions should be made in isolation. Fundamen-tal information is not merely historical; it also indicates whether acompany is financially soundor even solventtoday.

Key Point

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THE B IG P ICTURE20

Even without looking at a financial statement, you can learn a lot justby reading the recent headlines. Online brokerage services provide news for each company. For example, if you research Krispy Kreme (KKD) on Charles Schwab & Companys brokerage servicehttps://investing.schwab.comyou find the stock price, reports of rating services, compara-tive price performance data, and recent news headlines. Obviously, usingboth fundamental and technical information provides fast and reliable in-formation, and vastly improves a chartists information base.

The Primary Emotions: Fear, Greed and Uncertainty

Chartists employing a variety of strategies will usually agree on onepremise: Short-term price movement is predictable most of the time.Some chartists depend entirely on some specific patterns and tests withina price pattern. Others, like swing traders, believe that the cornerstone ofthe strategy is the three-part emotional trend that rules how most of themarket works. So greed, fear and uncertainty determine price patternsand make it easier to time and predict price movement.

Some swing traders describe the strategy as one that trades emo-tions, not stocks. But this is not entirely true. A wise trader will always beaware that stock selection is key to a smart program, so a starting pointshould be to pick stocks that are going to act and react to the normalmarket forces. If you pick a distressed stock (such as that Krispy Kremein 2005) or a stock that has risen in value beyond any fundamental ex-planation (like Amazon.com or eBay in the recent past), you cannot relyon the normal cyclical patterns of short-term charting; so those situa-tions may not provide reliable signals either. Later in this book, you willfind guidelines for picking stocks for swing trading.

Once you have limited your range of potential swing trading stocks,the timing of trades can be based on the three emotions that rule the

market. Market observers and the financial newsmedia like to give names to these emotional trendsother than the raw emotional names. When greedis in control, it is called a rally. When fear domi-nates and prices begin to fall, it is called a correc-tion. And when a period of uncertainty isdominant, that is referred to as a period of consoli-dation. The three market conditions are summa-rized in Figure 1.5.

rally

a period whenprices are rising,also known as acondition wheregreed dominatesthe market.

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The consolidation periodwhen uncertaintyrulesis sometimes described by analysts as a timeof agreement. In other words, under this inter-pretation, the current price range is agreeable toboth sellers and buyers. This is inaccurate. It is nota time of agreement at all, but rather a time whenneither buyers nor sellers dominate the market.During periods of uncertainty, the buying and sell-ing activity tends to be well matched, so that nochanges in supply or demand are evident. There isno agreement at all; both sides have no idea wherethe stocks price is going to go next.

In all three market conditionscharacterizedby the emotions of greed, fear and uncertaintyone fact remains constant: most traders do notlearn from their past mistakes. Logically, everyoneknows that no direction remains forever. When astocks price begins to rise, there is going to be alimit but greed ignores this. When the price is

The Pr imary Emot ions : Fear, Greed and Uncerta in ty 21

6462605856545250484644424038363432302826

Price

10 11 12 13 14 15 18 19 20 21 22 25 26 28Day

Uncertainty

Gree

d Fear

FIGURE 1.5 Emotions and the Market

correction

the description ofa market in whichprices are falling,when the emotionof fear dominatesthe market.

consolidation

a time when priceis not movingupward or down-ward, but remain-ing within anarrow tradingrange; a marketdominated byuncertainty.

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THE B IG P ICTURE22

falling, it cannot fall forever and at some point shares drop to a bargainprice level, but fear ignores that fact. And when uncertainty rules themarket (even if for only a few days) traders tend to become impatient.They either lose interest in the stock or make an uninformed decisionwhich is likely to be wrong at least 50 percent of the time. So holders willsell right before prices rise at the end of the uncertainty, or they buy rightbefore prices fall. These actions occur because traders act impulsively andemotionally. So with this in mind, you may add a fourth emotion: impa-tience. The impatient investor acts too quickly and makes a lot of timingmistakes.

Swing traders manage their emotions and simply observe the inter-action between the emotions of other traders and market prices. Thiscontrarian approach is more sophisticated than the common definition.A swing trading contrarian does not simply buy when most people areselling and vice verse; the more advanced version involves making deci-sions contrary to the dominant emotion of the moment. When pricespeak in a frenzy of greed, the swing trader looks for the sell signal. Whenprices fall rapidly in the ravages of fear, the swing trader remains calmand looks for the signal that the price has bottomed out. When uncer-tainty is the dominant emotion, swing traders resist the temptation todo something and remain patient until a signal emerges.

Before delving into more about specific swing trading examples,you need to review the basic rules of technical analysis and chart inter-pretation. The next chapter goes through these basics as a building blockto turning swing trading into a powerful market tool.

The market likes to give exciting names to upward-trendingprices, and to soften downward-trending prices. Thus you hearabout a rally (up market) versus profit-taking (down market); orenthusiasm (up market) versus caution (down market).

Key Point

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23

2The Basic Technical Rules

The tools used in technical analysis are price-related for the mostpart. They are visual in nature. Trading and price patterns are givengreat weight by technicians. In comparison, fundamental analysis

is a numerical study using financial results to establish recent trends andto predict future valueand thus price growth.

While fundamental analysis is backward-looking, technical analysisis intended to anticipate future price trends. Investors may use both ofthese approaches effectively to improve identification of risk, stock selec-tion, and the timing of decisions:

1. Identification of risk. When people hearabout risk, they tend to think of only onekind of risklosing money versus makingmoney. This is market risk and every stockinvestor faces this risk continually. Theidentification of this risk is elusive, how-ever, because so many aspects of the com-pany and the stock have to be considered.Chapter 6 explores the question of how to pick stocks based on financial condition

Chapter

market risk

the risk that astocks value willfall rather thanrise (or rise afteran investor sells).Market risk can becompared andjudged based onfundamentaltrends and techni-cal price history.

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THE BAS IC TECHNICAL RULES24

and capitalization; and those questions arethe starting point for identifying market risk.

Technical analysis includes comparisons ofprice and volatility, which is another aspect to mar-ket risk. The ideal swing trade stock is one with adegree of volatility. The price swings are required toachieve the variation needed in swing trading, so avery low-volatility stock will not work. On theother end of the spectrum, highly volatile stocks areunpredictable and not suitable for most swing trad-ing. The most suitable stocks, based on market risk,are those that tend to be moderately volatile, andthat trade within more than just a few points trad-ing range.

2. Stock selection. Picking stocks is, of course,the determining step in whether you achieveprofits or suffer losses. There is a tendencyamong investors to use methods for stock se-lection based on rudimentary technical signs,but these are often wrong. For example,some people buy stock because the price hasbeen climbing recently, or they sell sharesthat they already own because the price hasfallen. A rational method for stock selectionmay include fundamental analysis and athorough study of some key financial ratiosand trends; and technical analysis for thetiming of trades, among which swing tradingis one of the most effective.

volatility

the degree ofmovement in astocks price, andthe number ofpoints of move-ment from day today. The greaterthe price swing,the higher astocks volatility.Most investorsdefine market riskin terms of pricevolatility.

trading range

the normal trad-ing area extend-ing from thehighest to thelowest typicalprice. Stocks tendto trade within aspecific range.The broader therange, the greaterthe volatility andthus the greaterthe market risk.

Swing trading requires a moderate degree of volatility. Too littleswing in prices involves no trading opportunity; and too muchremoves the predictability of price trends.

Key Point

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3. Timing of decisions. Fundamental analysis is based on recent histor-ical financial resultsand this is a problem. The market is contin-ually changing, moment to moment. Technicians correctly pointout that fundamental analysis cannot be used for timing of trades.While the fundamentals can and should be used to pick stocks,you need to rely on technical signals for proper timing of buy andsell decisions. Swing trading is a valuable tool for this purpose.

Support and Resistance

The trading range of a stock is the price area in which that stock is beingbought and sold. This range establishes what is normal so that whenthe stocks price moves above or below that rangeor even when theprice tests the edges of the rangethose events are significant. In a nut-shell, this is how technical analysis works. It is all about setting up andunderstanding a few rules, and then deciding what it means when thestocks price breaks those rules.

Trading range can take several different shapes. The most basic one isbased on price, so that the trading range remains stationary. The top andbottom price do not change. A second type is the evolving trading range,in which the spread of the range remains approximately the same but theprice edges upward or downward. These three typesof trading ranges are illustrated in Figure 2.1.

When a trading range is evolving, technicianscall this pattern parallel price channels, and are usu-ally interpreted as foreshadowing a change in thetrading range in the near future. The level andspeed of an evolving trading range, a phenomenoncalled momentum, is also considered key in identi-fying how and when the trading range is going toadjust in the future.

Support and Res is tance 25

The trading range establishes the borders of what techniciansconsider normal for a stock. Any trading above or below thatrange offer a signal that important changes are about to occur.

Key Point

spread

the point differ-ence betweenhigh and lowprices within atrading range; thelarger the spread,the greater theprice volatility.

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The trading range is also defined by the all-important to and bottom price levels. As long as astock remains within a defined trading range, theselines remain intact. But when price exceeds theseprice lines, that means that big changes are occurringand a new trading range is going to be established.

The top line of the trading range is called theresistance level. This is the highest price that tradersare currently willing to pay for the stock. At thebottom is the support level, which is the lowestprice that sellers will accept to relinquish stock. Inthe never-ending interaction between buyers andsellers, the support and resistance lines provide adefinitive, price-based summary of the stocks cur-rent supply and demand levels.

Resistance and support are the foundations oftechnical analysis. They provide the standard bywhich a stocks performance is measured, in severalrespects. These standards include:

1. The spread and thus the volatility of the stock.The greater the swing in price from high tolow within the trading rangethe spreadthe greater the volatility. High volatility is themost commonly used measure of marketrisk, so the technician will judge stock safetybased on the spread itself.

Price

Stationary

StationaryEvol

ving Up

Evolving DownFIGURE 2.1 Trading Ranges

parallel pricechannels

the top and bot-tom edges of atrading rangewhen price levelsare evolving tothe upside ordownside, asopposed to arange in whichprices remainstable within therange.

momentum

in technical analy-sis, the rate andspeed of changesin price and trad-ing range, be-lieved to be adetermining fac-tor in how soon atrading pattern islikely to adjust.

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2. The trend itselfflat, up or down. The trendmay be flat or evolving and this also helpsto define the stock. Swing traders dependon a degree of volatility or the strategy sim-ply will not work; most short-term traderswill agree that they need some price swingsin order to put their trading strategies inplace. This is a short-term concern. Astocks price performance over the longterm depends on the strength of the funda-mentals for the company; short-term priceperformance is dominated by market emo-tions, and this is where moderate volatilityis advantageous.

3. The degree to which the trading range limitsare tested and what those tests imply. Techni-cians find themselves describing pricemovement as though the price itself wereconscious. So they describe a price trend asindecisive or aggressive. When the priceapproaches either resistance or support lev-els, technicians say that the price is testingthose limits. A test that does not succeed isusually taken as a sign that price is about tomake a move in the opposite direction;when the price does break through, that istaken as a significant development thatthrows the existing trading range into com-plete disarray and often leads to establish-ment of a new trading range. Manytechnicians like military analogies; so a

Support and Res is tance 27

Once the current trading change is violated and a new trend is set,a new trading range will be established for trading in the stock.

Key Point

resistance

the highest pricewithin a tradingrange, represent-ing the top pricethat buyers arewilling to pay forthe stock undercurrent conditions.

support

the lowest pricewithin a tradingrange, represent-ing the lowestprice at whichsellers will releasetheir stock undercurrent conditions.

supply anddemand

the forces deter-mining whetherprices rise or fall.Increases in de-mand create up-ward pricepressure, andincreases in supplycreate downwardprice pressure;supply and de-mand are thecauses of all stockprice changes.

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price breakthrough is described in the same way as a militarybreakthrough. It creates confusion and chaos and may lead to adisaster (or in the case of trading range, establishing a new frontline for resistance or support).

4. Actual changes in the trading range when price moves above or be-low established borders. Once a breakthrough occurs, a period ofvolatility often follows, after which a new trading range is set.This is inevitable. Stock prices cannot be expected to remainwithin a narrow trading range indefinitely, so emerging changesin trading range and even in levels of volatility are part of astocks life cycle. From the technicians point of view, the changesare interpreted based on how the price settles down. The newtrading range may be more volatile than the previous one, or lessvolatile. The previously stationary range may be replaced with anevolving one. The differences in price trend from one period toanother are the interesting features of technical analysis. The un-predictability of price trends can be overcome, from a technicalpoint of view, by accurately interpreting the signals.

5. The implications when a stock is so volatile that a trading range can-not be established. In some cases, a stocks price is behaving so er-ratically that no actual trading range can be established for theshort term. The price is entirely unpredictable. This creates aproblem for everyone because no technical interpretation is pos-sible. The volatility is caused by some important uncertaintywithin the market, but instead of the price settling down to a flatshort-term pattern, it becomes wildly unpredictable. This patternis invariably short-term and caused by a passing problem or per-ception. An astute technical analyst knows that at such times, anexamination of the underlying causes can help to estimate howlong the high volatility is likely to last.

Resistance and support are the defining attributes of a stocksprice behavior. For swing traders, short-term trading is more im-portant but the concepts of resistance and support provide im-portant signals.

Key Point

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The study of resistance and support and the way that price actswithin the trading range is important to swing traders because it helpsyou to anticipate likely price behavior in the next three to five days.While you are likely to depend on chart patterns and signals described inthe next three chapters, always be aware of the trading range as well. Itrepresents the price-based premise of a stocks risk level, price behavior,and future trends that have not yet developed fully.

The Advantage of Short-Term Chaos

Trading ranges bring a degree to order to an otherwise chaotic situation.No one knows what a stocks price is going to do next, just as no one canaccurately predict the broader market. The auctionmarketplace in which stocks trade is unpredictablebecause there are so many competing forces and in-terests involved. An economic model discusses sup-ply and demand as though buyers and sellersoperated with single interests and motives. In prac-tice, supply and demand is much different.

Because supply and demand are complexforces that interact on many different levels, pricesnever move in one direction indefinitely. When astocks price rises, some owners will take profits andsell. The more shares that are sold, the more pricesmove downward. This interchange is continual. Italso makes a difference when large institutional in-vestors (such as mutual funds, insurance companies,and pension plan managers) buy or sell blocks ofstock in a single move.

The individual investor, also known as the re-tail investor, accounts for only a small portion of to-tal trading volume. This does not mean thatindividuals have no control in the market. Institu-tional investors tend to make the same errors as in-dividuals; to trade on short-term emotion ratherthan logic; and to misread market signals. This ishow you can use swing trading to your advantage.Institutions are too complex and have too manystocks in their portfolios to make fast decisions; as

The Advantage o f Short -Term Chaos 29

institutionalinvestors

large investorssuch as mutualfunds, insurancecompanies orpension plans,holding diversi-fied portfolios ofstock and tradingin blocks ratherthan only a fewhundred shares.Institutional in-vestors accountfor most of themarkets treadingvolume.

blocks

large trades ofstock executed byinstitutional in-vestors in mostcases, usuallydefined as 10,000or more shares orstock with currentvalue of $200,000or more.

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an individual, you can ride the waves of short-termprice change and move in and out of positionsrapidly.

Short-term chaos is the retail investors advan-tage. Because your concern is for a small number ofstocks and a very brief time window, you can makefast decisions and still pay minimal trading costs;and maximize your advantage as a swing trader. Be-cause the short-term trend is always chaotic anddominated by greed, fear and uncertainty, you canexpect one thing consistently: price is going to over-react to any and all news. So if a stocks earnings area few cents below analysts expectations, the stockmay fall far more than the news justifies (only to ad-just itself to a more reasonable level within a fewdays). This is a swing trading opportunity, of course.

You will also notice that the chaos windowthe period of timewhen overreaction in either direction remains a controlling factorlaststhree to five days. This is why swing trading works well on that sameschedule. It takes three to five days for buyers and sellers to recognize theoverreaction in price and for the adjustment to get sorted out. In fact, thetime institutional investors need just to correct their positions in a stock(represented by large blocks) makes it impossible for them to act anymore rapidly. The disadvantage to institutional investors becomes thegreatest advantage to individual swing traders.

In this respect, you can predict how prices will change in the shortterm. A distinction has to be made here between short-term pricetrends and longer-term market trends. The primary technical system inplay in the market operates under the observations of the Dow Theory,developed by Dow Jones cofounder Charles Dow. Over a century ago,

retailinvestor

an individual, incomparison to aninstitutional in-vestor. The retailinvestor tradition-ally paid higherfees to trade,which explainsthe name. Today,any individualeven one payinglow fees with adiscount broker-ageis defined asa retail investor.

Investors desire predictability, but for swing traders, chaos cre-ates opportunities. Chaos fuels greed, fear and uncertainly, andthis fact is the swing traders great advantage.

Key Point

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Dow realized that trends were the key to estimatingfuture price movement. As his theories were fine-tuned over the years, the Dow Theory evolved intoa series of rules and observations which are usuallyapplied to the market as a whole and representedby the Dow Jones Industrials and other indexes.

The Dow Theory observes that a number oftrends can be observed within the broader market.A long-term trend, once established by an indexand then confirmed by another, establishes a mar-ket direction. However, short-term trends are dis-counted under the Dow Theory as unreliable.

This is true. If you are concerned with long-term trends for the entire market, you cannot relyon a two- to five-day price movement. More time isneeded, and a longer-term primary or secondarytrend has to be established. But swing traders are not concerned withthese kinds of trends. The trend a swing trader follows is the short-termtrend itself, which can be defined as the markets overreaction to virtuallyall news and all changes within the company and the individual stock. Inthis respect, swing traders observe the movements created by greed, fearand uncertainty, and make their decisions based on those momentaryfactors. You may pick stocks based on long-term growth and fundamen-tal strength, but you trade on emotions, not fundamentals. This is whereshort-term chaos can be used to maximize your advantage.

Breakouts from Trading Ranges

The short-term price movements within a trading range might be calledinsignificant. From a long-term point of view, this makes sense given thefacts. Short-term trends cannot be relied upon to estimate long-termgrowth. Fundamental analysts will agree with this universally. Even techni-cal analysts agree; but for swing trading, short-term price cycles are domi-nated by greed and by fear, and that is the key to swing trading success.

When prices shift in response to emotions, they are invariably exag-gerated. So a greed-driven price increase will exceed any rational or justi-fied growth in a stocks price; and fear-driven price declines will fallbeyond a rational or justified level as well. In this regard, swing traders

Breakouts from Trad ing Ranges 31

Dow Theory

a major technicalschool of thought,a belief that overall marketmovement ispredictable basedon primary andsecondary trendsand confirmingsignals. The DowTheory states thatshort-term trendsare not reliable for predictinglong-term pricechanges.

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base their trades on emotions and not spend time analyzing the underly-ing causes for price movement. Those causes do not matter because pricecycles are not reacting to any underlying cause; they are being driven bythose emotions.

This is a very short-term shift in price. Swing traders may also befundamental analysts and as long as you do not mix up the two differentschools of thought, you can perform in both roles. But the time comeswhen price moves above resistance or below support. This can occurwhen the emotions of greed or fear are so exaggerated that a frenzy takes

over, in which case it is likely that the price willeventually return to the established trading range.This is the exception; it is more likely that a break-out occurs because the stock price is on the way toestablishing a new trading range.

A breakout occurs in many different varia-tions, and following some specific charting pat-terns. Chartists rely on some of these patterns topredict a breakout. At times it is difficult to prop-erly interpret a current chart pattern, but easier toidentify in hindsight. Two breakout examples areprovided in Figure 2.2.

A breakout can be more dramatic than the ex-amples shown, with price levels moving far above orbelow established levels. A relatively low-volatilitystock can become highly volatile for a period oftime, only to settle down into a newly establishedtrading range at a different level than previously.When you look at a long-range stock chart, youcan spot the overall trends over many months or

Greed and fear create over-reaction, thus exaggerated swings inboth directions. By recognizing this tendency, swing tradersprofit from the tendencies of most investors. Remaining cooland collected leads to profits.

Key Point

breakout

a pattern in whichprice movesabove resistanceor below supportand establishes anew trend and,eventually, a newtrading range.

gap

a price pattern inwhich one daysopening price ishigher than theprevious dayshighest price orlower than theprevious dayslowest price.

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years, and this is where moving averages are valu-able in identifying specific trends. But short-termchanges in stock price levels can be very volatile, ifonly for a brief period of breakout and establish-ment of a new trading range.

Another significant trading pattern is the gap.As a general rule, stocks tend to open a new daywithin the high-low boundaries established on theprevious day. The gap, also called the common gap,is not unusual. When a stocks price opens above the high point of theprevious day or below its low point, a gap has occurred; and depending

Breakouts from Trad ing Ranges 33

Breakout Above Resistance

Breakout Below Support

Resistance

Support

Resistance

Support

Resistance

Support

Price

Price

FIGURE 2.2 Breakout Above Resistance; Breakout Below Support

common gap

another term forthe gap, whichdistinguishes itfrom other formsof exceptional gapchart patterns.

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on the ensuing price activity, a gap may come inseveral different forms.

The breakaway gap involves price moving into arange where it has not been in the recent past, this isa breakaway from the previously established trad-ing range. In comparison, the common gap takesplace within an established trading range.

Two additional kinds of gaps are important totechnicians. First is the exhaustion gap, which ap-pears after an extended period of price movementupward or downward. While the exhaustion gapcontinues in the same direction, it signals that theprice move may be coming to an end and the pricetrend will reverse. A runaway gap appears when aprice movement is gaining in strength; this kind ofgap reinforces the price direction, and a series ofrunaway gaps may even appear one after the other.

The major types of gaps are summarized inFigure 2.3.

Gaps are important to swing traders becauseof what they often signal. Gaps accompany majorchanges in directions occurring at the beginning ofnew price movements and also at the end of thesame trends. If you watch charts and see patternsindicating the timing is right to make a trend, andform of confirmation strengthens your decisionand improves your timing. Gaps serve as one of thebest forms of confirmation to enter or exit a trade.

breakawaygap

a gap involvingprice movementinto new territorybeyond the estab-lished tradingrange.

exhaustiongap

a type of gap inthe direction of anextended pricemovement, sig-naling that thecurrent trend isabout to end andprices will levelout or begin mov-ing in the oppo-site direction.

Gaps are very important chart patterns because they invariablysignal and reinforce important strength in existing trends, orforetell movement about to occur.

Key Point

runaway gap

a gap appearingas part of a strongand sustainedprice trend, rein-forcing the pricedirection, andpossibly showingup as a series ofgaps one afteranother.

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Important Chart Patterns

As a swing trader you do not have to become an expert in all aspects oftechnical analysisand some of it is quite complex. However, you doneed to master the basic charting principles and these are relatively easy.

There are two general tiers to technical analysis. The largest andmost complex is often overly theoretical and intensely mathematical.This level tends to be taught to students, and is more academic thanpractical. By the time you complete your analysis on this level, the stockhas moved onto its next phase and the information is out of date. On amore immediate and accessible level are a few important basics. This iswhere you can quickly gain the knowledge you need to improve yourtiming and your profits with swing trading.

The best-known signals are patterns called double top and doublebottom and these are fairly simple indicators to spot and to interpret. Adouble top involves two tests of resistance, with a decline in price in be-tween. Because it is a double test, the double top is considered a bullish

Important Chart Pat terns 35

Common Gap

Resistance

Support

Breakout Gap

Exhaustion Gap Runaway Gap

Resistance

Support

FIGURE 2.3 Common Gap, Breakout Gap, Exhaustion Gap, and RunawayGap

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signal, and the stock price is expected to retreat.The concept here is that there was not enough en-thusiasm among investors to push the price higher,so price retreats. The double bottom is the oppo-site, a test of support. Because support is strongenough to hold up under this two-part test, theprice subsequently rises.

The double top and double bottom are illus-trated in Figure 2.4.

double top

a price pattern inwhich resistanceis tested twicewith a pullback inbetween. As longas resistanceholds up, price isexpected to de-cline after thedouble top.

Double Top

Double Bottom

Resistance

Support

Resistance

Support

Price

Price

FIGURE 2.4 Double Top; Double Bottom

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The head-and-shoulders pattern is an ex-tended variation of the double top or bottom pat-tern. This is characterized by three price peaks ordeclines, with the middle one extending furtherthan the first and third (in a letter M shape). Ahead-and-shoulders top occurs at or near resistance;the interim trading areas between the peaks iscalled the patterns neckline. Volume often is strongat the first shoulder, and relatively weak by thelast phase of the pattern. The head-and-shoulderstop is a test of resistance and because it does notbreak through, it anticipates a price decline.

The head-and-shoulders bottom tests supportin the same way as the top tests resistance, but inthe opposite pattern, in a letter W shape. Volumeof the last of three head-and-shoulders extensions islikely to be lower than for the first shoulders andthe inverse head, indicating a lack of enthusiasmamong investors for a price decline. The head-and-shoulders bottom anticipates a rise in the stocksprice.

The two head-and-shoulders patterns each an-ticipate price movement in the direction opposite ofthe tests; and may also anticipate breakouts from theestablished trading range (below support after thetop pattern, or above resistance after the bottompattern). Both of these are illustrated in Figure 2.5.


double bottom

a price patterntesting supportwith a price in-crease in between.Because supportholds up againstthis two-part test,the double bottomanticipates a sub-sequent increasein the price level.

head-and-shoulders top

a price patternwith three peaks,the middle onehigher than thefirst and third.This letter Mshape patterntests resistanceand anticipates aprice decline tofollow.

neckline

the price area in between theprice extremes of the head-and-shoulders pattern.

The head and shoulders anticipates a reversal in price because itincludes three separate tests of the limits, accompanied byweakening volume. The reduction in enthusiasm of investors isthe real signal.

Key Point

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While the double top or bottom and head-and-shoulders patterns provide visual signals antici-pating specific price trends, another importantcharting feature is the broadening formation. Thereis a tendency for price ranges to expand over time,often with accompanying expansion of daily vol-ume. Several specific types of broadening forma-tions are useful to swing traders to recognizepatterns and to anticipate or confirm buy and sellsignals.

head-and-shouldersbottom

the inverse of atop, consisting ofa head testingsupport with twoshorter shouldersbefore and after,creating a letter Wshape. The pat-tern anticipates aprice increase.

Top

Bottom

Resistance

Support

Resistance

Support

FIGURE 2.5 Head-and-shoulders Patterns Top and Bottom

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The broadening formation is illustrated inFigure 2-6.

A related pattern is the triangle. This is the op-posite of a broadening formation in which a trad-ing range becomes narrower than the precedingpattern. This pattern implies uncertainty and whatmarket watchers like to term consolidation. Butwhile it precedes some future price movement, it isdifficult to determine with any consistency the di-rection that price movement is going to take.

The triangle is illustrated in Figure 2.7.The triangle has been given other names such

as flags, pennants, and wedges, but the over-all observation is the same: Any change to an exist-ing trading range anticipates a future pricedirection. A broadening formation reveals the like-lihood of stronger volatility in the future, and tri-angles imply momentary uncertainty.

No pattern can be reliably used to guaranteeprice movement. Even with the strongest of signals,short-term uncertainty dominates every stocksprice. But these patterns, when incorporated into


broadeningformations

chart patternsshowing wideningtrading range fora stock, develop-ing over time andproviding specificsignals for swingtraders.

FIGURE 2.6 Broadening Formation

triangle

a price pattern inwhich the tradingrange narrows, asign of uncer-tainty about thestocks pricemovement and aprecursor of acoming upward ordownward trend.

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the more specific daily price analysis used by swing traders, can serve aspowerful confirmation tools. When these are used along with the addi-tional information provided by candlestick charting analysis (discussedin Chapter 3), your arsenal of swing trading tools is vastly improved.

Spotting the Patterns to Trade Effectively

This brief explanation of charting patterns and signals is by no means ex-haustive. Chart patterns are general indicators that may confirm othersignals, and that is all. As you develop your swing trading strategy basedon a day-to-day analysis of price trends, you will find the broader chart-ing tools useful to time decisions. The purpose is to improve the timingand not to ensure 100 percent success. No system can do that.

FIGURE 2.7 Triangle

The triangle pattern can be equated with uncertainty that oftenis found between periods dominated by greed and fear. Forswing traders, this pattern can imply holding off any subse-quent swing trade opening trades until that uncertainty givesway once more.

Key Point

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It is always useful to keep market theories in mind. The randomwalk theory tells you that all short-term price movement is arbitrary. Onthe other extreme, the efficient market hypothesis claims that all currentprices are fair because they reflect all known information about a stock.Neither of these theories is entirely reliable. They do, however, provideguidance to the market and promote an understanding of how and whyprices move.

All theories aside, short-term price movement is always guided bygreed, fear, and uncertainty. As a period of uncertainty becomes ex-tended, a fourth emotionimpatienceis equally destructive as theother three. As long as you recognize that this range of emotions rulesshort-term price movement, you can employ swing trading to take ad-vantage of the cyclical changes in a narrow window.

Some specific guidelines for using chart patterns within your swingtrading strategy:

1. Recognize the limitations of pattern analysis as well as the benefits.Chart patterns are by no means the last word in timing of trades.Chart patterns may be thought of as the raw material of a moreextensive timing strategy. As you will see in the next chapter, theday-to-day price trends contain their own specific formationsand patterns that are not actually part of the broader chartistsrealm. A chartist looks for longer-term patterns with double topsor bottoms, head and shoulders, and other visual patterns over anextended period of time; and gaps provide an indication of morerapid changes in the moment. But these trends are limited invalue for swing trading. Because you will be observing trendsfrom one day to the next, your concern is focused on the actualtwo- to five-day swings within a few points and based on pricestructu

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[Michael C. Thomsett] Getting Started in Swing Tra