Reviewing
Different Types of Traders
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Before we focus
on swing trading, let's review all the other major styles of equity trading:
Scalping - The
scalper is an individual who makes dozens or hundreds of trades per day, trying
to "scalp" a small profit from each trade by exploiting the bid-ask
spread. (You can read about scalping in Introduction to Types of Trading: Scalpers.)
Momentum Trading
- Momentum traders look to find stocks that are moving significantly in one
direction on high volume and try to jump on board to ride the momentum train to
a desired profit. (You can read about momentum trading in Introduction to Types
of Trading: Momentum Traders.)
Technical
Trading - Technical traders are obsessed with charts and graphs, watching lines
on stock or index graphs for signs of convergence or divergence that might
indicate buy or sell signals. (You can read about technical trading in
Introduction to Types of Trading: Technical Traders.)
Fundamental
Trading - Fundamentalists trade companies based on fundamental analysis, which
examines things like corporate events such as actual or anticipated earnings
reports, stock splits, reorganizations or acquisitions. (You can read about
fundamental trading in Introduction to Types of Trading: Fundamental Traders.)
The Right Stock
The first key to
successful swing trading is picking the right stocks. The best candidates are
large-cap stocks that are among the most actively traded stocks on the major
exchanges. In an active market, these stocks will swing between broadly defined
high and low extremes, and the swing trader will ride the wave in one direction
for a couple of days or weeks only to switch to the opposite side of the trade
when the stock reverses direction.
The Right Market
It should be
noted that in either of the two market extremes, the bear-market environment or
raging bull market, swing trading proves to be a rather different challenge
than in a market that is between these two extremes. In these extremes, even
the most active stocks will not exhibit the same up-and-down oscillations that
they would when indexes are relatively stable for a few weeks or months. In a
bear market or a raging bull market, momentum will generally carry stocks for a
long period of time in one direction only, thereby confirming that the best
strategy is to trade on the basis of the longer-term directional trend.
The swing trader,
therefore, is best positioned when markets are going nowhere - when indexes
rise for a couple of days and then decline for the next few days only to repeat
the same general pattern again and again. A couple of months might pass with
major stocks and indexes roughly the same as their original levels, but the
swing trader has had many opportunities to catch the short-term movements up
and down (sometimes within a channel).
Of course, the
problem with both swing trading and long-term trend trading is that success is
based on correctly identifying what type of market is currently being
experienced. Trend trading would have been the ideal strategy for the raging
bull market of the last half of the 1990s, while swing trading probably would
have been best for 2000 and 2001.
The Baseline
Much research on
historical data has proven that in a market conducive to swing trading liquid
stocks tend to trade above and below a baseline value, which is portrayed on a
chart with an exponential moving average (EMA). In his book "Come Into My
Trading Room: A Complete Guide To Trading" (2002), Dr. Alexander Elder
uses his understanding of a stock's behavior above and below the baseline to
describe the swing trader's strategy of 'buying normalcy and selling mania' or 'shorting
normalcy and covering depression'. Once the swing trader has used the EMA to
identify the typical baseline on the stock chart, he or she goes long at the
baseline when the stock is heading up and short at the baseline when the stock
is on its way down.
So, swing
traders are not looking to hit the home run with a single trade - they are not
concerned about perfect timing to buy a stock exactly at its bottom and sell
exactly at its top (or vice versa). In a perfect trading environment, they wait
for the stock to hit its baseline and confirm its direction before they make
their moves. The story gets more complicated when a stronger uptrend or
downtrend is at play: the trader may paradoxically go long when the stock jumps
below its EMA and wait for the stock to go back up in an uptrend, or he or she
may short a stock that has stabbed above the EMA and wait for it to drop if the
longer trend is down.
