"Water shapes its course according to the nature of the ground over which it flows; the soldier works out his victory in relation to the foe whom he is facing. Therefore, just as water retains no constant shape, so in warfare there are no constant conditions."
Sun Tzu

Tuesday, March 29, 2011

Practical Swing Trading: THEORETICALLY Swing Trading is Easy

Theoretically, swing trading is easy: you buy the short-term pullback of a trending stock and sell into the new heights. I like this approach because it makes so much sense to me: to buy when others are selling and sell when the crowd is buying. Swing trading is in essence the application of two market inefficiencies, which can be statistically verified: momentum and mean-reversion. A broader discussion of these topics will probably be subject of a later post.

Unfortunately, swing trading sounds easy on paper, but there are a lot of nuts and bolts to it. But before discussing what could go wrong, let's look at a recent textbook example: Lululemon Athletica (NASDAQ: LULU). The stock gained 8.4 percent yesterday, according to stockcharts.com. So if you were a swing trader, should you have bought the stock at the close?

Let's discuss the recent price chart:

I like to keep it simple, so I do not use many indicators. Just two moving averages to define the trend, moving average envelopes to indicate the areas of "maximum optimism" where I should sell and relative strength vs. the S&P 500. The later one is my most important decision tool. Remember, we need to buy momentum and a stock that can resist negative market action is likely to show strength when the market goes up. Again, LULU is the perfect example.

In the last five months, LULU offered three swing opportunities, where the stock pulled back to its 20 day moving average while relative strength was rising: end of November, end of January and at the beginning of March. Not that I usually do not like to buy the first bounce. Instead I prefer to wait for a successful re-test of the swing low.

The sell points were also clear from the chart: when prices touched the upper channel boundary, it was time to sell. Remember, swing trading means to "buy the dip and sell the rip".

Let's take a look at the recent "buy signal": obviously, yesterday's close would have been too late to get in. There were a lot of good opportunities to buy the swing in the last weeks. At this point however, a swing trader is already looking for a good price to exit. The question is if LULU will experience volatility expansion, something, which can be better visualized using Bollinger Bands. In that case, a swing trader would simply hold the stock as long as price "walks the upper band".

I mentioned that swing trading is easy - THEORETICALLY. The recent LULU buy signal is one example of why this trading style might be not so easy to realize for most people. You needed to buy LULU in the first weeks of March, a time when very negative headlines dominated the news - Japan earthquake, Egypt, Libya, rising oil, end of QE2, etc. In addition, Jim Cramer was telling you to sell into strength and prepare for lower prices ahead. In order to be a successful swing trader, you need to blend out that noise. In my experience, not many people are capable of doing that and go against major headlines. Trading books didn't tell you that, did they?

On a final note: did I take the recent LULU trade? No I didn't. The stock was on my priority 1 watchlist, but so were others, such as BIDU, SGI or BX, which I currently own. I cannot trade everything. Maybe one day, if I'm a hedge fund, I might  be able to do so. :-)