Doc Maher explains how to refine your method with Advanced Orders.
I have noticed that many of you have various ways of getting into trades with different reasons for entry. Once active in a position, there are even more styles by which to manage these trades. In the following post I will explain a simple trading method, known as Swing Trading, that will hopefully help you improve your odds of profitability. I will also discuss how and why to use stop, stop-limit, and advanced orders with this technique.
Swing Trading is a newer twist on the traditional buy and hold strategy, but with a shorter time horizon. A swing trade usually lasts a few days to a few weeks.
THE PLAY - Buy Long Stock on a Pullback
TRADE FORMATION
On April 14, the following scenario occurred in AAPL stock:
High of the day: $149.25
Low of the day: $144.54
Most recent swing high: $159.69 on April 7
Target: $159.69
Potential entry: above $149.40 up to $149.50
Potential stop loss trigger: $144.50
Maximum gain: theoretically unlimited
Maximum loss: $149.50
Target gain: ~$10.19 (target - potential entry = $159.69 - $149.50)
Intended maximum loss: ~$5.00 (potential entry - stop loss trigger = $149.50 - $144.50)
Reward-to-risk ratio: $10.19 / $5.00 = 2.04
Time duration of trade: 2 to 6 days
ALL STAR COMMENTARY
In Swing Trading we take advantage of stock fluctuations within a trend. The idea is that trending stocks usually move in a step-like manner, or swing, rather than in a straight line. So while the overall trend is up, there will be small "pullbacks" during the trend. If the trend is down, there will be small "bear-rallies." (To read more about the bearish side, please check out my previous post Frustrated by Getting Stopped Out.) The theory is that these pullbacks (or bear-rallies) offer us a better-odds entry. Below is an example of what I am talking about.
Click here for a larger image.
Entering on the pullbacks gives me a better chance of profiting as the trend resumes. I enter when the stock starts back up and place my stops below the swings. Then it's just a matter of managing the stops and taking profit at the appropriate times. These trades usually last two to six candlesticks. So for a daily chart I am talking about two to six days. For a weekly chart it would be two to six weeks. Of course if things keep moving in the right direction, the trade could last longer.
To illustrate, let's look at a recent historical case. Here is AAPL on April 7, 2008:
Click here for a larger image.
The first thing I look for is a trend. It also helps if I am bullish for other reasons, such as sector strength or strong fundamentals. In the above chart you can see AAPL has a pretty good uptrend. However I don't want to enter it now because at any time it could go into a pullback. If that happens, I might get stopped out, while still being correct about the overall trend. The higher percentage play is to wait for the pullback and then enter.
Click here for a larger image.
Let's advance in time and zoom in a little. The above chart is AAPL on April 14th. As you can see it pulled back from its high on April 7th. If I had entered on the day of the high, I probably would have been stopped out. So instead of jumping in, I'll wait for the stock to turn back up. When this happens, I will have a local (swing) low. At the close on April 14th, AAPL was trading at 147.78. As a guideline, I will enter only if AAPL goes above the high of April 14 ($149.25). I'll put my stop below the low of April 14th ($144.54). This is what I hope will become the swing low, but I won't know until the turn back up is made.
But how do I do that? What kind of an order do I want to use? I need an order that will let me wait until the price of AAPL goes above $149.25 before I buy. This is called a Buy Stop Limit Order. The "Stop" is the price I want my order to "trigger". Another way to say trigger is "become activated." Once triggered, a "limit" order to buy becomes live. The "limit" of this order is the most I am willing to pay for the stock. (As a side note, a "Stop Limit" order is usually used to enter a position and not to exit.)
So in this case, I want to enter above the April 7th high of $149.25. Let's say if AAPL gets to $149.40, I want to buy (stop or trigger price), however I don't want to pay more than $149.50 (buy limit price). If my order activates and I buy AAPL for $149.50 or better (or less) I will also want to limit my losses. In order to do that, I need to set a Sell Stop Order. As I said, this would be around the low of April 14th. But I only need the sell stop order if I get into the trade. This is done by combining the buy stop limit order and the sell stop order by using a One Triggers Other or OTO order. The second order (sell stop) will only go into effect if the first order is filled. This will limit my loss to $5.00 (entry of $149.50 - stop loss of $144.50).
The next thought you might be having is a potential loss of $5 too much? Too little? How can you tell the difference? I need to determine if the reward-to-risk ratio is acceptable. We have calculated the risk, but what's the reward based on? The way I do this is I start with the most recent high, which in this case was $159.69 on April 7th. This becomes my target and gives me a potential reward of $159.69 (target) - $149.50 (entry) = $10.19. So my reward-to-risk ratio is $10.19/$5.00 = 2.04. As long as this is two or better I consider the risk acceptable to enter the trade. What this means is that even if AAPL only goes back up and tests the previous high, it will have been worth making this trade based on the risk and reward.
This doesn't mean that I can't stay in the trade if AAPL goes higher than the target, it is just a way for me to determine if the risk is worth taking. Whenever I am trading enough shares I will usually take some off the table when I hit the target. That way I ensure some profit at that level. The rest I will let run until stopped out, however I'm going to move my stop up as the stock increases.
Here is what the order looks like. The first image is for the Buy Stop Limit. The second image adds the Sell Stop by using a One Triggers the Other (Stock-Stock). Note that this choice is the Advanced Orders drop down box.
Click here for a larger image of the Buy Stop Limit Trading Screen.
Or here for the One Triggers Other Trading Screen.
Now this is set up for a classic swing trade. Next time I'll show you what would have happened and how to manage this position.
Until then,
"Income Trader"
Doc's previous posts: Frustrated by Getting Stopped Out and Are Repair Strategies Worth It?
For a list of previous All-Star Trades, please click here.
Would you like your Trade Note to be chosen? Read more.
Nicole Wachs contributed to this post.
Any strategies discussed and examples using actual securities and price data are for educational and illustrative purposes only and do not imply a recommendation or solicitation to buy or sell a particular security or to engage in any particular investment strategy. In reading content in the Community, you may gain ideas about when, where, and how to invest your money. Although you may discover new ideas or rationale that may be compelling, you must ultimately decide whether or not to put your own money at risk. Consider the following when making an investment decision: your financial and tax situation, your risk profile, and transaction costs.
Jonathan F. Maher, PhD has a professional business relationship with TradeKing.
