The 11 Commandments of Swing Trading

My, we sure have come a long way since our first trading lesson! For starters, I'd like to thank you for giving me the opportunity to teach you a bit more about my trading methodologies and technical analysis as I practice it, as well as a chance to introduce you to my premium weekly investing newsletter -- the StreetAuthority Swing Trader.

In today's final lesson I'm going to begin with a recap of Lessons #1 through #4. After that, I will provide you with a final lesson that should prove to be the most comprehensive and valuable yet -- The 11 Commandments Of Swing Trading.

1.  A LOOK BACK AT OUR PREVIOUS TRADING LESSONS  
2.  THE 11 COMMANDMENTS OF SWING TRADING DEFINED  
3.  THE 11 COMMANDMENTS EXPLAINED  
4.  CONCLUSION AND A LOOK AHEAD

(1.)  A LOOK BACK AT OUR PREVIOUS TRADING LESSONS

In Lesson #1 I introduced you to the relationship between swing trading and technical analysis. The better you become at technical analysis, I noted, the more efficient and profitable your swing trades will be. I showed you how important it is to recognize the trend in the time frame you are trading. I used the example of Silicon Image (SIMG) to show you what a great swing trading set-up looks like and how with trades like this one you could reap profits of 50% or more in just a few trading days/weeks.

As a journalist and educator, I noted that my commitment to you was twofold. First, I would scour the markets and share the best trades I could find with you each week. Second, I would teach all that I knew from my more than 30 years of technical analysis study.

In Lesson #2 -- The Power of Trendlines -- I began to fulfill this teaching commitment as well as to show you how I uncover profitable trades. Although there are many, many tools in the technician's toolbox, the simple trendline, I asserted, is still one of the most powerful.

You were shown how to recognize an uptrend -- a series of higher highs and higher lows -- by labeling peaks and valleys. When this pattern reversed itself and became a series of lower highs and lower lows -- a downtrend -- it was time to nail down profits. You then became better acquainted with the trendline and received clear directions on how to draw both simple and complex trendlines. My goal was to present this information to you in a clear, easy-to-follow, step-by-step way (something that is very difficult to find either in books or on the web).

I then showed how just by using this one tool, the swing trader could harvest significant profits in a short period of time. For those interested in honing their skills, I presented a practice chart for KLAC-Tencor (KLAC) and asked you to interpret its trend. In my subsequent lesson I provided an "answer" to that chart by defining two profitable trades on KLAC based upon the very simple principle of buying on the break of the downtrend line and selling on the break of the uptrend line. In the first trade I went long; it yielded profits of more than 55% in just over a month. The second trade I went short and gained 33% in about 30 trading days.

In Lesson #3 -- A Swing Trader's Secrets of Support and Resistance -- I showed you how you can use support and resistance to earn substantial profits. I began by demonstrating how support and resistance come from a variety of sources, such as moving averages and trendlines. However, I noted that they are mainly detectable at horizontal levels above or below the present price.

Next, you learned about how an uptrend consists of a period of sharp movement -- the reaching of a peak -- and then the drifting back toward the previous price level as profits are taken. Finally, I explained that the uptrend can resume only by breaking through the peak that had at first turned it back. You saw how this insight could be both profitable and could create low-risk entry points for you.

I then showed you the difference between simple and significant support and resistance -- a distinction I have not seen made in any other technical analysis works. In weak markets, I argued, you can initiate profitable and safe swing trades on the break of support. In strong markets, you should buy on the break of resistance, particularly when the volume signature supports the trade. I then introduced you to just two of the dozens of classical technical analysis price patterns, and you saw how recognizing and trading on these patterns could help you multiply your trading capital many times over.

In Lesson #4 -- Swing Trading By Candlelight -- I explored another aspect of technical analysis by showing you how I use candlesticks in short-term trading. By recognizing a handful of candlesticks, you learned how to potentially call every major turn in the S&P 500 in a six-month period. At every major turn, I showed you how candlesticks provided an early warning indicator, one that foreshadowed a change in trend even before the trendline broke. Even though we covered only a few of the many technical tools available in this trading course, I demonstrated to you how the principle of multiple indicators could assist you in making safe and profitable trades.

In today's final lesson, my goal is to provide you with an in-depth look at my trading strategy, tactics, principles and attitudes. I use these exact same strategies to uncover profitable trading opportunities for my StreetAuthority Swing Trader newsletter each and every week. By studying and incorporating them into your existing market framework, they should also help you execute your own winning swing trades. I call these my "11 Commandments of Swing Trading." Here they are...

(2.)  THE 11 COMMANDMENTS OF SWING TRADING DEFINED

1.  Always align your trade with the overall direction of the market, which is best measured by the S&P 500.  When trading "industrial' stocks, do not fight the major trends.
A strong stock will typically make little headway in a weak market. Meanwhile, a weak stock will often underperform even in a bullish period. With this in mind, you should always clearly determine the market's primary and intermediate trends before you pick any individual stocks to trade. (And by an "industrial stock," I mean those highly correlated with the S&P, such as manufacturing, financial or retail issues. On the other side of the coin, "resource" stocks such as gold or oil are often inversely correlated with the major averages.)

2.  Go long strength. Go short weakness.
Once you know the overall trend, do not fight the tape. Look for long trades during periods of bullishness. Find appropriate short trades when the bear is on the prowl.

3.  Always trade in harmony with the trend one time frame above the one you are trading.
Sure, we've all heard the clich� -- "the trend is your friend." But which trend are people referring to? Use moving averages to be in tune with both the short- and intermediate-term trends, even through as a swing trader you are only trading for the short term.

4.  Never trade only on the short-term chart of the swing-trading time frame. Be sure to SYNTHESIZE the messages that the weekly, daily and even hourly charts are telling you.
Use your telescope as well as your microscope when you look at charts. Too small a lookback period -- using the microscope only -- can be very deceptive and costly.

5.  Strive to enter the trade near the beginning of the trend, not near the end.
It is never too late to hop on the elevator. If the market is headed from the 95th floor down to the 78th, you can still profitability climb on board (short) on floor #83. But the quicker you recognize that a trend has begun, the more profitable your trade will be and the less risk you will assume.

6.  Always apply the rule of "multiple indicators." Do not trade on any one technical tool or concept in isolation.
Highly profitable trades usually occur when all available technical tools give the same message. Candlesticks, volume, moving averages, and indicators such as stochastics and MACD occasionally all align to communicate the same message -- the stock is about to sharply rise or fall.

7.  Keep your eye on the ball. Track a consistent group of stocks.
As a swing trader, it is easy to flit from hot stock to hot stock. Although it's okay to follow the action, you should also have a core group of stocks that you track daily and learn the personality of.

8.  Always enter a trade with a clear trading plan. The four key elements of the plan are a target, a limit, a stop loss and an add-on point. And when you sell, you should immediately determine a re-entry level.
Swing trading can lead to impulse buying. Sometimes your impulses can turn out to be profitable, but other times they may not be. Remember: without a clear plan you are merely gambling, not trading.

9.  Strive to put the odds in your favor. Ask yourself, "Does this trade have a 2:1 risk/reward ratio?"
Don't risk a dollar to try to make a dime. On good trades, your chart analysis should always show more upside possibility than downside risk.

10.  Be a "techno-fundamentalist," not just a technician. Integrate fundamentals into your technical analysis.
Day traders in positions for 15 minutes to an hour have little need for fundamentals. Swing traders, on the other hand, may often hold positions for several days to several weeks. As such, they can greatly benefit from a better understanding of each company's fundamental, inherent value.

11.  Master the "inner game" of swing trading. Great trading is psychological as well as technical.
Always keep a positive mental attitude about your trading. Do not let bad trades affect you longer than necessary. Learn from your mistakes; poise yourself to make your next trade.

(3.)  THE 11 COMMANDMENTS EXPLAINED

1.  Always align your trade with the overall direction of the market, which is best measured by the S&P 500.  When trading "industrial' stocks, do not fight the major trends.

Every week in my StreetAuthority Swing Trader newsletter, I begin by discussing the market's primary and intermediate trends as measured by the S&P 500.

These trends provide the context in which every swing trader must make short-term trading decisions. If you focus only on the short term, then although your trade may be successful for a limited time period, the larger trends are apt to reassert themselves. At best, your profit potential will be limited. As such, you need to identify the longer-term trends to make sure you go with the flow and not against it.

Over the years, I've observed that "surprises" such as news announcements, analyst upgrades/downgrades and earnings hits/misses almost always occur in the direction of the larger trends. Swing traders should always be cognizant of where the S&P stands in relation to its longer-period moving averages, such as the 40-, 30- and 10-week. Below I've presented you with a historical chart of the S&P 500. Note how except for very brief periods of time, the long-term trend (as measured by the 30- and 40-week moving averages) and the intermediate trend (as measured by the 10-week moving average) remains a downward one.

2.  Go long strength. Go short weakness.

Let's assume for a moment that the bear is on the prowl. The 40- and 10-week moving averages are both sloping downward and the S&P is beneath both. In this scenario, you should always look for stocks to go short, NOT to go long.

Always incorporate Price Relative to the S&P 500 ($SPX) into your chart analysis. This indicator will tell you how the individual stock is performing in relation to the overall market. During bear markets you should seek out stocks whose relative strength line is trending downward in relation to the S&P. Do the opposite during bull markets.

Below you'll find a historical chart of H&R Block (HRB). This short, which I recommended in early 2003 during a period of market weakness, turned out to be a very profitable trade for StreetAuthority Swing Trader readers. During a period of S&P decline, HRB's relative strength was weakening in relation to the market.

3.  Always trade in harmony with the trend one time frame above the one you are trading.

Many short-term traders focus their technical analysis exclusively on the short-term chart. However, this type of technical analysis will always end up being partial or limited because these traders do not see the big picture.

On the other hand, you should not focus exclusively on the primary trend when swing trading. Even in a bear market, there are periods where the intermediate trend turns positive and stocks soar. These bear market rallies can be enormously profitable. Fueled by short covering, the S&P 500 and other major averages can climb 20% or more in a period of just several weeks. Meanwhile, volatile stocks with high "betas" can move much, much more than this.

Even though you are a short-term trader, it is vital to know when the intermediate-term trend is changing and a countertrend rally is taking hold.

Below you'll find a historical chart of the S&P 500. Coming off deeply oversold levels each time, you'll note that this chart presented traders with three very tradable countertrend rallies. Each was forewarned by certain "signatures" left by Bollinger bands, stochastics, MACD, RSI and several other technical tools that I use on a regular basis.

In my weekly StreetAuthority Swing Trader newsletter, I always monitor these trends for you and alert you when the intermediate trend is about to turn. Moreover, in each weekly issue I dedicate several pages to teaching you how to better use these tools yourself so you can make better independent decisions.

4.  Never trade only on the short-term chart of the swing-trading time frame. Be sure to SYNTHESIZE the messages that the weekly, daily and even hourly charts are telling you.

My first step when analyzing a stock is to look at a two-year weekly chart. I examine the shares in relation to a long-term moving average and determine the overall trend. This weekly chart is ideal for examining the big picture.

Next, I focus on the 6-month daily chart. Here, I can see finer details that the weekly chart obscures. I use much shorter-term moving averages to ascertain the stock's short-term trend.

Finally, I often hone in on the hourly chart to discern the prevailing trend over the last couple of weeks. Again, moving averages are extremely helpful here.

My final step is to synthesize all of this analysis. Is the stock telling me a clear, relatively unambiguous story? Are the shares breaking out from resistance or breaking down from support with confirmation from volume and other indicators such as RSI? Is this story sufficiently similar in all three time frames? Have I interpreted the story early enough so that I can go short or long with solid profit potential and minimal risk?

In the two historical charts (weekly and daily) below, note that Dentsply (XRAY) formed a double top in late October 2003. This made a very profitable swing trade for those who recognized this formation. Had you shorted on the break of support at $37.50 and covered at the next support level down ($32.50), then you could have made an impressive +13.3% in just one short month!

Not all stocks communicate quite this clearly though. In fact, some remain in extended periods of sideways consolidation. A symmetrical triangle formation, for instance, is almost impossible to predict and trade. Similarly, an MACD that gives signal after signal in a short period of time is a totally unreliable indicator.

5.  Strive to enter the trade near the beginning of the trend, not near the end.

The earlier you pick up on the change in trend, the less risk you will take and the greater your profits will be. The most important step here is to pay close attention to the overall market averages. When they are overbought or oversold, they are usually prone to reversal.

Researchers and analysts have developed a variety of indicators to detect when the broad market is prone to a reversal. Some of these include the McClellan Oscillator, the Arms Index, the Volatility Index and the Put/Call ratio. When the market tests a major zone of support and resistance it is very useful to look at new highs and new lows and the advance/decline line. I often discuss and interpret these indicators in my premium StreetAuthority Swing Trader newsletter. If you chose to sign up for a longer-term subscription to my newsletter, then you'll certainly benefit from further in-depth discussions of these indicators in my weekly "Inside The Black Box" column.

Most "industrial," or non-resource (papers, metals, oil, gold) stocks are highly correlated with the direction of the overall market. Therefore, when the market turns they are likely to turn as well. Candlesticks and momentum indicators such as RSI and stochastics are what I describe as early warning lights. They often anticipate or lead a turn in the stock.

By contrast, trendlines and moving average crossovers are lagging indicators that merely confirm the message of the early warning signals. Depending on your willingness to take risk, you can trade on either a leading or a lagging indicator. When both types of signals have been given, you generally can enter the trade with a high probability of success.

6.  Always apply the rule of "multiple indicators." Do not trade on any one technical tool or concept in isolation.

The rest of this trading lesson is available exclusively to paid StreetAuthority Swing Trader subscribers. 

Good trading!

Dr. Melvin Pasternak
Editor
The StreetAuthority Swing Trader