In my voyage to teach myself active trading I figured one of the best places to start would be a “for Dummies” book, so here’s my review of Swing Trading for Dummies.
Note that most of this book is about technical analysis and I cannot reproduce the charts used in the book. This summary is best used by somebody who will read the book and use it to call back to the knowledge gleaned from the book.
Defining Swing Trading
The author defines swing trading as a strategy that is markedly different from both day trading and buy-and-hold investing.
Where day traders sell out of their entire portfolio daily to not be affected by opening gaps up or down and pick trades based on intraday technicals, swing traders will hold their positions for weeks or months and will allow fundamentals to have a material impact in the trade decision.
Where buy and hold investors will focus on creating a diversified portfolio that can pull through any macro dips, swing traders will try to trade around the dips: buying when the market is going up and shorting when it is going down.
Enter and Exit Using Technical Analysis
There are two steps to technical analysis
- The four main chart types are:
- Line charts simply connect the dots from one price period to another, typically using the closing price
- Bar charts show the open, high, low and closing price of a security on that day, distinguishing which if the stock open or closed higher with a line protruding from the bar
- Candlestick charts show the same thing as bar charts but distinguish whether the open or close was higher by the color of the bar
- Point and figure charts use X’s to represent up movements and O’s to represent down movements
- Prices where sellers outnumber buyers and the stock seems to hit a ceiling are termed resistance
- Prices where buyers outnumber sellers and the stock seems to hit a floor are termed support
- Prices typically move through four phases:
- Accumulation, a channel of shifting between support and resistance with light volume because wall street generally thinks the security is priced correctly.
- Expansion, is when the stock trends up. This typically starts with a higher than normal volume day and is signaled by the support transitioning into the resistance
- Distribution, follows the expansion phase. Institutions are starting to take profits and volume is starting to taper off, but general interest in the stock from its price run-up keeps the price in a channel until…
- Contraction, is when all gains developed during the expansion are given back. Short sellers should use temporary rallies as entry points during the contraction period.
- The head and shoulders pattern is marked by three sequential highs with the middle high being the highest (think a stock hitting $8 and then falling back, $10 and then falling back and then $8 again). This typically signals a down trend.
- The cup and handle pattern is the opposite of the head and shoulders pattern
- Trend lines are drawn by connecting highs or lows together. If three connected together create a straight line the stock is likely trending.
Learning Technical Indicators
- The first step is learning whether or not the security is trending: if you use an overbought indicator to short a security in a strong uptrend you will get burnt.
- Use only a few indicators and stick to them.
- The best signals to enter or exit a stock are when the technical indicators diverge from the stock price.
- The Average Directional Index (ADX) will show if a security is trending or not. Readings above 30 show a security as trending and readings below 20 show that it is stuck in a channel.
- If a security is trending use the following indicators
- Pick a moving average and enter when the slope changes from flat or negative to positive and vice versa
- Buy when a short-term moving average crosses over a longer-term moving average
- Use MACD to buy when the MACD line crosses over its 9-day moving average, the zero line or when there is a divergence from the stock price
- If a security is not trending use the following indicators:
- Stochastics compare the current price to a range of recent prices. Trade when the stochastics action diverges from the price action (e.g. the stock hits a recent low but the stochastics do not).
- The relative strength index is range bound between 0 and 100. Above 70 equals overbought and below 30 equals oversold. You can also trade when a stock hits a new high or low that is not confirmed by the RSI.
Use Fundamental Analysis to Pick Stocks
- Wait until after a quarterly report to trade so that the results are baked in and there are no surprises
- Analyze the balance sheet to determine financials strength
- Look for companies with large cash and working capital balances
- Look for companies that do not have a lot of debt compared to equity
- Be wary of large increases in inventory or accounts receivable
- Assess the income statement next
- Compare sales growth rates to net income growth
- Look at margin trends
- Watch for dilution from share growth
- Focus on wide moat companies with high insider ownership
- Wait for catalysts
- Value the company either by comparing it to peers or deriving value from only its own cash flow or book value
- Screen stocks by value metrics to look for opportunities
- Limit position sizes by percent of capital or risk level. Don’t invest in a stock that could decrease total capital by more than 7%
- Create stop losses based on a trailing percentage or a time period