Swing Trading, The Basics: Part 1

This is an exclusive extract from Michael Thomsett’s new book, Options for Swing Trading. We’ll be running extracts from Michael’s book all throughout November and you can even win yourself a copy by entering our competition here, or read on below for details on how to claim 30% discount through Littlefish FX.

“No endeavor that is worthwhile is simple in prospect; if it is right, it will be simple in retrospect.” – Edward Teller, The Pursuit of Simplicity , 1980

You have a great advantage in the market. Individual investors can move quickly in and out of positions without having to worry about the effect of their decisions on broader market prices. This is no small point in the evaluation of swing trading strategies. Institutions cannot swing trade effectively due to their size in terms of dollar value and shares owned.

Large institutional traders transact billions of dollars each day, which means that they have maximum influence over the market as a whole in terms of trading activity. Institutional trades account for about 70% of all trades in the market, so their influence cannot be ignored. However, do institutional trades distort or control stock prices? Evidence suggests that they do not.

Two theories about institutional influence are worth understanding. First is the effect of herding , a belief that institutional demand destabilizes stock prices. Herding is a practice among institutional investors in which managers follow one another in and out of the same issues. This crowd mentality, in fact, is witnessed not only among institutional investors, but also among individuals (“retail investors”).

The second theory is that institutions tend to not make decisions based on fundamentals, in spite of widespread belief that they do. The belief is that because fundamental strategies take too long to create profits, institutional money managers tend to follow technical and short-term strategies. In other words, institutional managers may acknowledge the advantages of short-term trading strategies such as swing trading. The big question is: do such practices affect prices in the broad market?

An extensive study of this question included price analysis of hundreds of stocks traded by institutions. That study concluded that there is

no consistent evidence of a significant positive correlation between changes in institutional holdings and contemporaneous excess returns. . . . We conclude that there is no solid evidence in our data that institutional investors destabilize prices of individual stocks. Instead, the emerging image is that institutions follow a broad range of styles and strategies and that their trades offset each other without having a large impact on prices.

Options for Swing TradingIt appears that the belief in institutional power to control prices is not well founded. In fact, it seems more likely that individuals have a great advantage in exploiting short-term price trends because they do not have to figure out how to transact thousands of shares at the same time.

This is the essence of swing trading. The conclusion of the study that institutional managers do not necessarily follow fundamental principals is startling and will surprise many conservative mutual fund investors, shareholders in insurance companies, and beneficiaries of pension plans, all of whom take comfort in the fundamental and conservative investing objectives so often stated by institutions. In fact, those money managers see the same things that swing traders see, momentary advantages in price trends that can be acted upon to create small but consistent profits.

Swing trading is a contrarian approach to extremely short-term price movement. Anyone who tracks the market has observed that in specific conditions stock prices tend to move to an exaggerated degree, but correct within a few sessions. For example, an earnings report misses estimates by a few cents, and the stock plummets four points. Within two days, the entire drop (or most of it) has been recovered, and prices stabilize within the previously established trading range.

Why does this happen? The tendency of the market is to be extremely chaotic in the short-term trading cycle due to the attributes controlling the market. The crowd, that nameless, faceless majority, tends to act and react emotionally. The two prevailing emotions in the market are greed (seen when prices rise or when good news appears) and panic (seen when prices fall or bad news appears). The consequence is that price movement is exaggerated.

The swing trader acknowledges this irrational attribute of the market and resists the temptation to follow greed and panic reactions. Taking a contrarian approach, the swing trader recognizes these overreactions and does the opposite of the crowd. When prices jump suddenly in an exaggerated reaction to good news, the majority tends to want to jump on board and get in on the action. This means a majority of buy orders show up right at the top of the swing. The swing trader looks for this irrationally exuberant timing and takes a bearish position, knowing that the exaggerated jump in price is likely to retreat.

The same is true with bad news. A majority of traders sell when bad news is announced, driving prices down and creating panic among even more traders. This is why a small negative earnings report might cause a drop of several points in prices. The swing trader recognizes the panic moment and takes up a bullish position, knowing that prices will be likely to recover these losses.

Swing trading is contrarian, not because timing of entry and exit are the opposite of those chosen by the majority of traders at such times, but because the decision is rational rather than emotional. This is essentially the key to contrarian investing—following the logic of market movement rather than following the emotional overreaction of the majority.

Stay tuned for Part Two: It’s All About Timing, and enter our competition to win a copy of Options for Swing Trading here.

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