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Essential elements of swing trading
Previously, we have learned the objectives of swing trading, but before starting, it is essential to go through a basic checklist. Some of these are explained below:
1. Liquidity - Swing trading requires that the trader can enter into or exit from trades quickly. Therefore, it is extremely important that trades are entered in only liquid stocks.
2. Time frame - Swing traders should use multiple time frames (hourly, daily, weekly, etc.) in order to gauge market sentiments more accurately– one minute, five minutes, fifteen minutes candlesticks are too small a time-frame to judge the suitability of the trade. Ideally, such short time frames should be employed by day traders who must square off their positions at the end of the day.
3. Volume -The number of shares traded is also an important indicator to consider in the charts. Any trend accompanied by high volumes is a good indicator of a trend continuation.
For example, a price breakout from a range bound zone with good volumes is a more potent indicator for traders to enter than a breakout accompanied by low volumes. Volumes act as a confirmation to the trade. Volume represents market interest in a stock, higher volume shows market interest in the trend that the stock trades. If a stock falls with huge volumes, it is indicative of bearish market sentiment in participants, similarly if price rises with huge volumes, it is indicative that market sentiment with regard to the stock is bullish.
In the above chart of Adani Ports & SEZ (NSE: ADANIPORTS) we can see that the price candle at ₹880 is accompanied by huge volumes and subsequently the price falls below ₹720 pointing to the bearish trend in the stock.
Thus, analyzing volumes is an important tool for swing traders.
4. Entry & exit points - It is extremely important for swing traders to have a strategy for determining the entry point of trade. Since this strategy requires timing the market to ensure profits, it is essential that traders choose accurate entry points based on their chart analysis. Generally, swing traders enter into trades at pullbacks when they intend to follow the trend after some retracement or at the lower/upper end of the band when trading a range-bound stock.
Similarly, the exit strategy must be pre-determined. The exit strategy is usually based on important technical price levels or is determined using the risk-reward ratio as explained in the next point.
5. Risk reward ratio - Risk to reward ratio is a fundamental requirement of any trading strategy. It represents the trader’s target and the maximum loss that the trader is willing to bear in the trade
Generally swing traders work with a 1:2 Risk Reward Ratio or higher.
For example, a trader buys a stock at ₹500. The stop loss that he sets based on his risk-taking capacity is 3% of ₹500 = ₹15 i.e., The trader can at maximum afford to lose ₹15. Therefore, as soon as price hits ₹485 (₹500-₹15) trader exits position to prevent more possible losses.
With a 1:2 risk reward, trader targets 2x his risk i.e., 3*2=6%. Therefore, he targets 6% of ₹500=₹30. Thus, as and when the stock hits ₹530, the targets are achieved and he exits the stock
In the 2nd example, a trader short sells a stock at ₹1,000. The stop loss based on risk is 3% of ₹1,000 = ₹30. i.e., The trader can at maximum afford to lose Rs.30. Therefore, as soon as price hits ₹1,030 (₹1000+₹30), the trader exits position to prevent more possible losses.
With a 1:2 risk reward, trader targets 2x his risk i.e., 3*2=6%. Therefore, he targets 6% of ₹1,000= ₹60. Therefore, if the price hits ₹940 (₹1000-₹60) = ₹940, trader’s targets are achieved and he exits the stock.
6. Stop loss - Trading without a stop loss is a sure-shot way to blow up your account. Swing trading involves significant overnight risk as the trades are held for more than a day. Hence without a stop loss, any runway gap ups or gap downs can lead to significant erosion of capital.
As a general piece of advice, traders must not risk more than 2% of their risk capital in a single trade.
For example, if somebody has a capital of say ₹10,00,000, their total loss should not exceed 2% of their capital i.e., ₹20,000 in a single trade.
7. Risk management- Risk management essentially means all the steps that traders take in order to preserve their capital. This can be achieved by doing a combination of three things:
- Exit on stop loss/ target- Swing traders should exit their trade on achieving their desired target/ hitting stop loss. Greed of more price action in your favor or hope to recover losses can render the strategy useless and can lead to loss of capital beyond determined levels.
- Trailing stop loss- A winning trade should always be held with a trailing stop loss. Consider a trader who has initiated a long trade on the stock of ABC Corporation at the Current Market Price of ₹100 with a stop loss at ₹95. Suppose, the stock moves in your favor and reaches a price point of ₹115.
Ideally, he should sell the stock given the price target has been achieved. However, in case if the trader feels that the stock has more room to run, he can keep trailing his stoploss higher- 1st to the breakeven point and eventually higher so that notional profits are locked. The trader may also book partial profits as the target levels are achieved.
8. Consistency - Once a strategy has been developed & thoroughly back tested, it should be continued and not changed haphazardly based on tips/advice. Stick to the mantra to plan your trade and trade your plan!
For example, if a trader is comfortable with successfully executing trades based on moving average indicators and has chosen a few stocks in which the trend is amply clear, he must continue using that strategy.
Blindly following other strategies/indicators with no domain knowledge of its setup coupled with executional inefficiency can have disastrous results. So it is always better to learn first; hence we will discuss some swing trading strategies in our next unit.