Shark Radar

Broader review of the most significant events worldwide
Apr 12, 2021, 1:11 PM GMT

The Intricacies of Swing Trading

Behind the George Washington Statue looking towards the New York Stock Exchange on Wall Street

Buy Cheap, Sell High

Undoubtedly one of the most popular types of trading strategies out there, swing trading is used to catch significant portions of unfolding price trends. Part of the reason this approach is so widely used has to do with its appeal to the most basic trading assumption - the desire to buy cheap and sell high. While this surface-level assumption definitely holds true, swing trading is much more intricate than that.

Swing trading typically involves the execution of positions that can span from several days to several weeks. At any rate, the duration of such trades can exceed a single session, which may bear overnight costs. Additionally, swing traders run the risk of catching massive gaps at Monday's open from events that have taken place over the weekend. On the other hand, positions that span more than several days are better suited to negate the impact of intraday fluctuations in the price action, which is what allows traders to focus on the 'big picture'.

Understanding the Risk

The biggest advantage of swing trading has to do with the possibility of evaluating the risk-to-reward outlook of any given trade before its execution. Namely, traders can determine whether the potential profit outweighs the undertaken risk of such a trade before they execute it. If the trader determines that he stands a good chance of catching profits that exceed the underlying risk, say, three times, then opening such a position will be warranted. On the other hand, placing an order when the potential risk/reward outlook has a ratio of, say, 1:1, the trader may be justifiably reluctant to open such a trade.

Notice the price action of crude oil futures (current contract in front) on the daily chart below. It demonstrates the current opportunities for utilising classic swing trading methods.

The price of crude oil looks ready to break down into a new downtrend, suitable for swing trading

Catching the Perfect Entry

The first goal of every swing trader is to determine whether the market is ranging or trending. One of the easiest ways to do so is to utilise the Wyckoff Cycle theory, which differentiates between Distribution/Accumulation ranges and Markup/Markdowns. The breakout above the upper boundary of the Accumulation range (the major resistance level at 43.60) signalled the beginning of a new Markup. This represented the first hint for swing traders that they could join the newly emerging uptrend.

The second goal is to spot a trend continuation pattern in the new trend, which would allow swing traders to join it in anticipation of further directional price action. The two rectangles manifest such trend continuation patterns on the chart above. The breakouts above them signalled suitable entry levels, whereas the two lower boundaries of each rectangle highlighted the preferable areas for placing stop-loss orders.

At present, the price action of crude oil futures is contained within the boundaries of a significant Distribution range, spanning between the major support level at 57.60 and the major resistance at 66.60. Naturally, swing traders will be eying to catch the emergence of a new Markdown, which would represent the logical continuation of the Distribution range.

In order to determine the potential risk from selling ahead of time, swing traders can use the Fibonacci retracement levels to determine the crucially significant targets for the newly emerging downtrend. These Fibonacci levels represent the crucial retracements from the peak of the previous uptrend, which makes them such prominent targets.

A breakdown below the Distribution's lower boundary (57.60) can be interpreted as the first sell signal. However, bears should be cautious of potential pullbacks within the boundaries of the Distribution. Such pullbacks can reach as high as the 23.6 per cent Fibonacci at 59.88, which is why a stop-loss order should be placed above it. In other words, bears looking to sell below 57.60 stand to lose at least $2.28 per barrel on such a short trade (Risk Area 1).

More risk-averse traders, in contrast, can wait for the price to break down below the 38.2 per cent Fibonacci at 54.86 before they sell. They would naturally place a stop-loss order at (or slightly above) the Distribution's lower boundary at 57.60 (because then it would be the closest resistance). Hence, their total risk will amount to $2.74 per barrel (Risk Area 2).

At first glance, the second scenario entails more risk (0.46 cents per barrel); however, swing traders will likely draw a different type of comparison between the two. Traders choosing the first scenario would have to consider the possibility of the price action finding support from the closest Fibonacci retracement, which in this case would be the 38.2 per cent. In other words, they would stand to win essentially what encapsulates Risk Area 2. Hence, unless the price manages to break down below the latter, traders who chose scenario 1 would face a risk/reward outlook of roughly 1:1.

On the other hand, traders preferring scenario 2 would notice that the next target for the price action (after it breaks 54.86) would be the final 61.8 per cent Fibonacci retracement at 46.74. They stand to win $8.12 (54.86-46.74) per barrel, which encapsulates the Profit Area (in green). With a potential risk of $2.74 and a potential profit of $8.12, these swing traders would face a risk/reward ratio of almost 1:3 (2.96).

While the risk/reward outlook of scenario 2 is much better than scenario 1 (three times better), the ultimate decision of where to sell would depend mostly on each trader's own risk-aversion. While scenario 2 strives to provide entry into a more robust trend, scenario 1 entails better prospects for early entry, which could prove more profitable in the long-term (Profit Area + Risk Area 2).

Swing trading is thus at its most efficient when it is complemented with thorough fundamental and psychological analyses.