Understanding The Theory Of Swing Trading
The application of technical analysis involves a study of historical price and volume data to first identify and then trade the existing trend. Through the use of pattern analysis and other indicators, this discipline also helps traders and investors alike to identify any change of the current trend and spot reversal. This article focuses on swing trading
Investors usually prefer capturing long-term trend. However, there are short-term traders who actively trade to capture short-term price movement within a primary trend. This method of trading is known as ‘swing trading’. It is a trading style that focuses on taking trades that last a couple of days up to weeks in order to profit from an anticipated price move. The basic tenet of Dow Theory describes three basic trends in price action: uptrend, downtrend and sideways trend (no trend).
Usually a trader, while avoiding a sideways trend, will try and capture a primary uptrend or a downtrend to ride the trend in the security on a long or the short side. A short-term trader, however, understands that no trend, even if it has a strong trend, does not move in a parabolic manner on either side. Within the broad trend, there are always ‘reactionary’ moves in either direction. A swing trader captures such moves through the use of different indicators. Such a move or a trade captured over a short-term within a primary trend is called a ‘swing trade’.
Day Trading versus Swing
Trading Swing trading and day trading may seem the same, but there are major differences between the two methods of trading. The first major difference is the time factor. Day trading involves buying and selling of securities within a same day, whereas swing trading focuses on taking trades that last a couple of days up to weeks in order to profit from an anticipated price move. The second major difference is the level of commitment. Day trading involves sitting in front of your trading screen all day and monitor moves of the markets since in day trading a market participant is constantly hunting for new trading opportunities throughout the day.
Swing trading is less time-intensive as positions are reviewed periodically or handled by setting alerts when key price points are reached rather than requiring constant monitoring.
Swing Trading Merits
1. Decent Returns: The main goal for a trader is to earn profit and a trader practicing swing trading trades with an objective to make decent returns on a trade.
2. Helps to Avoid Over Trading: Over trading is the biggest reason why traders lose their money and swing trading helps to avoid over trading as in swing trading the quality of trades is important, not the quantity.
3. You can Trade Part-Time: Many professionals look out for a second source of income but they are not able to devote much of their time due to commitment to their full-time profession. For such professionals, swing trading can be a best option as in swing trading you will probably only make several trades per week and nothing if there is no opportunity. In short, swing trading allows you to fit trading in around whatever busy schedule you may have.
Swing Trading Demerits
1. Overnight Holding Risk: Swing trading involves holding a position for several days to weeks. So, they are exposed to risk of gaps, which can happen when there is some market news after the market hours. These gaps could lead to heavy losses if it goes against the investor.
2. Possibility of Missing on Exceptional Stocks: Swing trading aims to profit from price swings. A swing trader enters trades at the beginning of a new swing and closes the trades when a pullback starts. But in doing so, he or she misses out on a great stock that would have made more money if held as a long-term investment.
Now that we have discussed what swing trading is and are pretty much familiar with its merits and demerits, let’s move on to discuss the important strategies for swing trading.
Moving Averages
Moving average is a popular trend-following indicator. This indicator does not forecast the price direction but defines the current direction of the stock price. This is a lagging indicator because it is based on past price data. Despite this, it helps to smooth the price action and filter out the noise. The simple moving average (SMA) and the exponential moving average (EMA) are the two most common types of the indicator.
Moving averages can be used in three ways:
1. Trend identification
2. Support resistance
3. Moving averages crossover.
Trend Identification
Instead of predicting the top or bottom, following the trend is much easier. Hence, most of the traders or investors use moving averages to identify the trending direction. The direction of moving averages gives important information about the price i.e. when the moving average is in a rising mode and the price is above the moving average it shows that the bulls are in the driver seat and the trend is up. While on the flip side, when the moving average is in a falling mode and the price is below the moving average it indicates that the bears are in the driver seat and the trend is down.
In the above chart, the stock of Aarti Drugs Limited has surged above its short-term 20-day simple moving average on April 3, 2020 and thereafter the stock has gained nearly 590 per cent in just five months. During this period the 20-day SMA was continuously in a rising mode and moreover the price was above the moving average, which indicates the stock is in an uptrend.
In the above chart of ACC Limited, the stock has slipped below its 20-day SMA level on January 31, 2020 and thereafter the stock has witnessed correction of over 40 per cent in just 36 trading sessions. During this period the stock is continuously trading below its 20-day SMA level and the moving average is in a falling mode. This indicates the stock is in clear downtrend.
Moving Averages as Support and Resistance
Another way to use moving averages is to use them as dynamic support and resistance level. The moving averages are dynamic support resistance because they are constantly changing depending on the recent price action. In a bullish trend, the moving averages act as support while in the downtrend they act as resistance.
In the above chart, the stock of Birlasoft Limited is clearly in an uptrend as it is marking the sequence of higher tops and higher bottom and trading above its short-term moving average. During its upward journey, for multiple times the stock has witnessed a throwback. The throwback has halted near the 13-day exponential moving average line (EMA) and after taking support at the 13-day EMA the stock continued its ascent.
Moving Average Crossover
The moving average crossover occurs when the short-term moving average (fast) crosses through a long-term moving average (slow). This indicates that a strong move is likely to come as the momentum of short and long term is shifting in one direction. The use of single moving average may produce lots of whipsaws in the absence of a strong trend. In this situation, the moving average crossover helps to reduce the whipsaws because it identifies the major momentum shift in both short and long-term direction. Swing traders typically use the 12-day with 26-day SMA and 20-day with 50-day SMA crossover, while 50-day and 200-day SMA is most popular among the long-term investors.
In the above chart of Larsen and Toubro Limited we see a crossover of 20 and 50-day moving average. The green line represents 20-day moving average and the yellow line represents 50-day moving average. In early November 2020 we had seen a crossover as the green line moved above the yellow line and the rest is history since the stock has seen a rapid rise and delivered over 50 per cent return.
Final Thoughts
Every trader enters into market with a goal to make money, but many don’t know how to start as there are different methods through which trader can achieve their ultimate goal of making money. So before starting out it is important as a trader to understand which method or style is most suited to you. If you are a working professional or an individual who wants to devote only a limited time and wants to skip all the market ‘noise’ of short-time frames than swing trading is the perfect option for you. As swing trading does not require dedicated screen commitment like in-day trading and at the same, it is rewarding as the focus is on taking quality trades over time, which is exactly what you need to do if you want to reach to your ultimate goal.
Interview
Milan Viashnav, CMT, MSTA,
Consulting Technical Analyst and Founder, Gemstone Equity Research And Advisory Services
Relative Strength Index
There are many indicators used by short-term investors and traders for swing trading to capture short-term trades. Each indicator will have its own characteristics and a trader would use the one he is most comfortable with. Among many, one such indicator that can be applied for swing trading is Relative Strength Index (RSI). This is a leading indicator. The price follows this indicator and therefore it remains one of the most popular indicators used by short-term traders and investors for swing trading.
Developed by J Welles Wilder, RSI is a momentum oscillator, and it measures the speed and change of price movements. Instead of comparing with another security, the RSI measures the strength of price movements of a stock against its own self, usually over the past 14 days. Therefore, RSI will usually have a 14-day period as its default look-back and measuring parameter. How can this be applied to swing trading? RSI, which is a bound oscillator, moves in the range of 0 to 100. Generally, it is considered ‘overbought’ above 70 and ‘oversold’ below 30. Just like the price chart, the RSI can also be subjected to pattern analysis with formations like higher or lower tops, higher or lower bottoms, rectangles, etc. RSI can be applied in two ways to capture swing trades:
1. Bullish or bearish divergence in RSI against the price
2. Pattern breakout or a breakdown in RSI before the price. This can be better understood with the following examples.
Example : 1 In this example 1 shows a bullish or a bearish divergence of RSI against the price to enter a swing trade.
In the first instance, the price was seen making higher highs; the RSI did not confirm with this which resulted into a bearish divergence of RSI against the price. Following this, the moment the stock violated its immediate support, it resolved into a sharp downside. Similarly, in the second instance, notice now the price action formed lower lows on the price chart. At the same time, the RSI was marking higher bottoms. This resulted in a strong bullish divergence of RSI against the price. The moment the stock moved past its resistance, it marked an initiation of a sharp uptrend. This example shows how a pattern analysis of the RSI and its breakout or a breakdown can be used to enter a swing trade.
Example : 2 In the above example 2 , RSI is subjected to a pattern analysis just like the stock price. The RSI showed a pattern breakout, and this happened much ahead of the price action. Following this, the price resolved with a breakout after a few days. RSI, being a lead indicator, signalled this swing trade much ahead of the actual price breakout. Similarly, in the second example, notice how the RSI violated its support line. The RSI broke its support much ahead of the actual price, breaching its support. The RSI warned of this price action much ahead of the actual price breaking down.
