How To Add A Layer Of Discretion To Your Swing Trading
In my
articles and book on swing trading, IÂ strive to make the rules as specific
as possible. However, the market doesn’t always conform to specific
rules. Therefore, you occasionally have to add a layer of discretion. Below I
discuss a few ways in which discretion can be used to help improve your swing
trading.
Good Close/Bad Close
In general, we are taught that “good” setup closes in the top of
its range (for longs). The theory is that the buying that lifted the stock into
the close will continue on the following day. However, there are times when
stocks that closed poorly might be considered. One such case is when market
conditions themselves are poor. A stock with a poor close is less likely to
trigger on the following day, should market conditions remain poor. This will
help to keep you out of the market during these times. On the other hand, if the
stock does trigger, it suggests an impressive reversal as the stock was able
recover all of the prior day’s losses. And, it could suggest a major reversal
back into the direction of the original trend.Â
This brings us to another form of
discretion, fading gaps.Â
Fading Gaps
Stocks that close poorly (for potential longs), often gap lower on the
following day, as existing longs “throw in the towel” and new shorts
are attracted to the market. The gap down can often represent a panic low or
near low for the day. In the case of a pullback (or any setup for that
matter), you might look to enter in the direction of setup and against the
direction of the opening gap, provided it shows some sign of reversing back into
the direction of the underlying trend. Often, this allows you to get a head
start on those that won’t be triggered until the prior day’s high is taken out.
This is illustrated below and discussed in further detail in my article “Opening
Gaps: Trade ’em, Fade ’em or Ignore ’em”.
Early Entries
In addition to fading gaps (mentioned above), there are occasions where you
might look to enter a setup before the actual trigger is hit. I’ve dubbed this
“front running” a setup. This usually works best when the setup
is very obvious — possibly “textbook” in nature. In these cases,
provided the market and the sector are in gear, you might look to enter just
below the obvious entry (usually above the prior high for longs). You can then
use a tighter-than-normal stop and look to re-enter just in case you are too
early.Â
Higher Entries
In general, unless the setup dictates otherwise, the entry (for longs) is
normally just above the prior bar’s high. However, there are instances where you
might want to enter above the prior 2-3 (or more) bar highs. The best case for a
higher entry is when the recent highs are fairly close to the prior bar’s high.
The advantage is that the stock might not make it through this resistance level
and you will avoid a potentially losing trade. And, because the entry is only
slightly further away from a “normal” entry, you don’t give up too
much of the stock’s move. This is illustrated below.
5, 10, 15, 20, 25?
When the exchanges implemented decimalization, I
quickly realized that professionals were often able to push stocks at least 1
cent above/below the prior day’s high/low, in order to trigger stops. Therefore, I
immediately begin using at least 5 cents above/below the prior high/low for
entries.Â
Taken one step further, I also discovered that if a stock closed well
(for longs), I wanted my stop even further away to help ensure that I would not
get caught in a false move. Why? Because stocks that close well have a very good
chance of showing some initial follow-through but after that, there’s no
guarantee the stock will continue higher. Therefore, by placing an entry well
above the prior high, say 10 to 25 cents depending on the close, I was able to
avoid these false moves. Â
On the other hand, on a poor close, the stock is
less likely to trigger on the following day. And, if it does trigger, it shows
that the stock has very strong intraday strength. Therefore, when a stock
closes poorly, I usually place an entry stop very close to the prior day’s high.
In fact, on a very poor close, I might put the entry at the high or even look to
enter early (before the trigger).
Second Entries
In choppy markets, the first move a stock makes will often be a false move.
Therefore, in these instances, you might want to allow a stock to trigger and
observe its behavior before taking a position. By avoiding the first push, you
can then look to position yourself if and only if the trend
resumes. The advantage is that you will often avoid a losing trade, should the
stock reverse and never “re-trigger.” Obviously, the trade-off is that
you risk missing a winning trade should the stock trigger and keep on going.
Notice above that the stock pushed above the entry
(a) but
immediately reversed (b). In choppy markets, the original trigger can often be
the high or near high of the day. Waiting for a second entry (c) (possibly
slightly above the original entry/intraday high) helps to ensure that
the stock will keep going in the intended direction.Â
Stocks often gap open to their high (or near high) for the day. Therefore, by
waiting a few minutes to see if the gap “sticks,” and then looking to
enter above the morning range, often a losing trade can be avoided.Â
I have
illustrated this common pattern below.
Taking Partial Profits
Ideally, when taking partial profits, you should make at least the amount you
risked on half of your initial trade. Otherwise, the winners won’t be enough to
cover the losers. However, sometimes, during choppy market conditions, the
market will tempt you by coming within cents of your intended profit goal before
backing off. During these times, you are often better off taking the less-than-ideal partial profit.Â
This is illustrated below.
On the other hand, if a market is really flying, you might want to trail a
stop intraday to capture a greater-than-intended partial profit.Â
This is
illustrated below.
Protective Stops
Most of the time, the protective stop should go below the lowest low in the
setup. If this is more than 5% away from the entry, IÂ normally
suggest not risking more than 5% of the stock’s value. However, on lower-priced
stocks and/or very volatile stocks, this stop probably has a better-than-average
chance of getting hit. Therefore, you might want to use a somewhat looser stop
and trade fewer shares.Â
If the low of a setup is very close to the entry, say less than
2 points for
a higher-priced stock, I might risk at least 2 points to help ensure that I
don’t get stopped out on the normal “noise” of the market alone. See
my articles on volatility
and Learning
From A Loss for more information here.Â
A Cardinal Sin?
As you know, I always preach the use of protective stops. However,
there are some cases where a stop could be pulled and then replaced. The
most common argument for “pulling a stop” is when a stock is called to
open sharply against your position. This is often caused by some sort of bad
news, or events that transpire overnight. The next opening represents a potential
panic situation as traders look to exit at the first possible chance. Often,
these panic opens become the low or near low of the day. Therefore, in these
situations, you might want to pull your stop and see if the stock will bounce
within the first few minutes of trading. Keep in mind that this requires the
utmost discipline and you must have an “uncle point” (i.e.,
where you will exit no matter what) just in case the stock gaps lower and keeps
on going. This “repair strategy” will be covered in detail in an
upcoming article.Â
Trailing Stops
As you know, one of my favorite trailing-stop techniques is to use a 2-bar
low. For instance, if on Monday the stock hits a low of 99 and on Tuesday hits a
low of 100, then my stop for Wednesday will be around 98.90 — just below the low
of the prior two days. Now suppose that the stock had a sharp rally and closed
at 110 on Tuesday. I might not want to give up over 11 points of profit
(110-98.90). Therefore, I would likely adjust my protective stop to within
several points of the closing price. On the other hand, if the stock closes very
close to the bottom of its 2-bar low, I may want to give it a little more room,
say a point or two below the close, provided of course the stock still looks
promising.
It Ride
In general, I tend to exit my swing trades within 2-7 days. However, I occasionally
have the opportunity to hold a piece of position for extended periods of
time. In these cases, I have already taken half of my profits when they exceeded
my initial risk and have moved my stop to breakeven (see my money
management lessons for details). Therefore, I essentially have a
“free” position on the remaining shares (barring overnight adverse
gaps). I’m now in a situation where I can give the stock more room to
breathe. So, rather than trailing the stop tightly, say at a 2-bar stop or
some price percentage away, the stop could be placed below prior correction
point/s (a). This longer-term stop could then be adjusted higher should the
stock continue to “stair-step” higher. This is how what starts out as
a swing trade can occasionally turn into an extraordinary longer-term gain.
To The Letter?
When I define a setup, I usually try to be as specific as possible. This helps
to weed out lesser setups. However, many times the pattern doesn’t fit the
setup to a “T” but still may be worthwhile. In these cases, as long as I
can justify the pattern from a conceptual standpoint, IÂ might still be
interested. For example, with pullbacks, I normally like to see at least three but
no more than seven days from the high (for longs). However, there are instances
where I might find a stock that has only pulled back 2 bars interesting. By the
same token, I might also consider stocks that have pulled back for more than 7
bars. For example, in my stock column I mentioned
Mentor Graphics
(
MENT |
Quote |
Chart |
News |
PowerRating)
as a pullback after it had pulled back 3 bars. I continued to mention the stock
even after the seventh bar because I felt, in the bigger picture, the stock was in a
strong uptrend and had the potential to resume its rally.
The Ultimate
Discretion — Not Trading
Your own equity is the best measure of your performance and/or the
performance of your methodology for the present market conditions.Â
Therefore, if your equity curve has been heading down of late, it may reflect
either personal problems or poor market conditions for your methodology. It is
at these times you might want to avoid trading altogether and then slowly ease
back in when new opportunities present themselves. See “My
Most Valuable Trading Lesson” for more on this subject.Â
Taking It Further
In this lesson, I have barely scratched the surface on how discretion can, and probably
should, be used in swing trading. I urge you to study these and, more importantly,
develop your own layers of discretion through market observation and experience.
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