TABLE OF CONTENTS Introduction: Why So Many Pros Swing Trade 1. The Perfect Setup - What and When To Buy 2. When To Sell 3. How To Be More Profitable 4. How To Manage Risk 5. How and Why To Time the Market About the Author Disclaimer Copyrigh t Introduction - Why So Many Pros Swing Trade There are two major ways to consistently make money in the market: 1) Hunt for several huge winners in a year. Build large positions in them and ride them for monstrous gains. 2) Hunt for hundreds of 5% to 30% short-term winners, where the goal is to compound capital quickly by actively moving in and out of them. There is not right or wrong approach here. Both have place in the arsenal of each active market participant. Everything comes at a price. If you want to catch a 200% to 300% long-term winner, you have to be willing to sit through multiple consolidations and several bigger than 30% pullbacks. Not everyone has the stomach to ride big stock market gainers, but maybe you don’t have to. If you sell all your winners, when they are up 20%, you will never catch a double or a triple. Fact. What is also true is that in any given year, there are a lot more 20% moves than 100% moves. If you learn how to catch hundreds of quick 5% to 20% moves, your capital could appreciate very quickly while you keep you keep the drawdown in your account to a minimum . Swing trading is among the fastest way to grow capital if you learn how to properly apply its principles. Swing trading is all about velocity and opportunity cost of capital. The goal is to stay in stocks that are moving quickly in our favor and avoid “dead money” periods. Stocks move in 5% to 30% momentum bursts that last between 2 and 10 days, before they mean-revert or go into sideways consolidation. The goal of every swing trader is to capture a portion of a short-term momentum burst, while avoiding consolidation periods. Then to repeat the same process hundreds of times in the year by risking between 0.5% and 1% of capital per idea. The beauty of swing trading is that it provides many signals. You don’t need to risk a lot per signal. You won’t second-guess yourself whether to take a signal or not. One trade is not going to make your year or your month, but it also won’t ruin it. It relies on the magic of compounding. The idea is to grow capital quickly by being leveraged to the hill during favorable periods and being mostly in cash during unfavorable periods . I know that if you apply the principles I describe in this book, you will become more knowledgeable, more profitable and happier market participant. Here is a brief overview of what you could expect to learn: 1) What drives short-term market moves? How to recognize perfect swing setups; when to buy them and where to put your stop losses. 2) When to sell and how. 3) How to be more profitable. How to improve your success rate and where to hunt for big short-term gainers. 4) How to manage risk properly. How to decide how many shares you should buy of every stock you like. How to check if you have an edge in the market. 5) How and why to time your market exposure. Chapter 1. The Perfect Setup - What and When To Bu y Benjamin Graham said that the market is a voting machine in a short-term perspective and a weighing machine in a longer-term perspective. Exactly. Valuation matters if you plan to hold 10 years. What drives stocks today, this week, this month and for the purposes of swing trading is sentiment. There is no better measure of real market sentiment than price. There’s an unwritten market rule called the 80/20. Many stocks have 80% of their appreciation in just 20% of the days. The rest of the time they spend in sideways consolidation. A swing trading approach aims to put us in stocks during their range expansion period. What is a Perfect Swing Setup? Swing trading is about taking advantage of market structure - range contraction is often followed by range expansion; consolidations tend to continue in the direction of the established trend. A great risk-to-reward swing setup has several factors going for it and they are all price related: 1. Previous uptrend. 2. Near 10-day high (within 3% of it) . 3. High relative strength on weekly, monthly, quarterly or half year basis. 4. Tight side-ways consolidation on below average volume, lasting anywhere between 2 and 20 trading days. 5. The closing prices of the past few trading days are very near to each other. 6. Stock is coiled near its 5, 10 or 20-day moving average. 7. Stock is trading above its 5-day moving average. 8. Stock’s 5-day moving average is above its 20-day moving average. Here are a few examples of what we are looking for: The Psychology behind this setu p Financial markets move in cycles that are defined by institutional moves. When institutions buy or sell, they do so in volume and leave clear traces for the experienced eye. Do you know how the perfect setups we are looking for get formed? Basically the process is the following: 1. There is a catalyst (earnings or price related) that causes a stock to break out. 2. Let’s say that in our example, our stock of interest runs from 30 to 40 in a week. 3. It is normal to expect some form of mean-reversion after such an explosive move – either through time or through price. 4. Institutions that are not willing to chase, could just put a big bid at 38, so every time this particular stock drops to 38, supply will be absorbed. 5. The stock will remain in this 38 to 40 range until the entire supply is absorbed and there is enough demand to push the stock higher. How To Find Swing Setups with Great Potentia l I go through a 1000 charts every day and it takes me about 30min. I look at multiple smaller charts on one screen. Some of the screens that I go through: § Stocks up >10% in the past week; § Stocks up >20% in the past month (use >10% if you are looking for large caps); § Stocks up >30% in the past quarter (use >20% if you are looking for large caps); § Stocks up >40% in the past 6 months (use 30% if you are looking for large caps) The purpose of going through those scans is three-fold: 1. Find stocks that are likely to break out soon; 2. See if there is an industry that is setting up for a breakout; 3. See what is currently working in the market - no better way to learn how to find great setups than analyzing big winners from the recent past in various time frames . Yes, I could run screens that would substantially decrease the universe of stocks that I have to go through, but by saving time, I am going to rob myself from the opportunity to get a feel for the current market. How do you become good at recognizing setups? By studying past winners at various time frames - this exercise will not only help you realize what you should be looking for, but also it will help you find future trading candidates - stocks that are setting up for another leg higher. When you do that for a while, you will realize that the same setups that work beautifully in a bull market have very high failure rate in a choppy market. I am looking for setups with different periods of relative strength for a reason. The shorter-term relative strength scans – weekly and monthly are likely to capture stocks at the beginning of their rally. The longer-term relative strength scan – 6 month, aims to capture stocks that have been trending up for a while and might be entering into their parabolic phase. The context of each swing setup is of utmost importance: The most money is made at the beginning and the end of trends, because no one believes the moves. Don’t be afraid to go after swing setups in stocks that are up 100% in a few months - these are exactly the stocks that could deliver mindboggling returns of 30 to 50% in week. Don’t be afraid to swing trade stocks that have just started their trend and are relatively unknown. There are two major types of swing setups: 1) Buying a breakout (breakdown) from a proper base. 2) Buying in anticipation of a breakout (breakdown) What is the difference between a breakout and an anticipation setup? In both cases, we are looking for vehicles (stocks) that used to move with 100 miles per hour, but are currently moving with 10 miles per hour. An anticipation setup requires buying when our vehicle of interest is still moving at 10 miles per hour. A breakout setup requires buying when one of those vehicles accelerates its velocity from 10 to 30 miles. Breakout Setu p Stocks move in a constant cycle of range expansion and range contraction. Buying a breakout in a perfect setup aims to put us in stocks that are entering into range expansion mode. What are the characteristics of a great breakout setup: § Low-volume range contraction (2 to 20 days) § Up from the open >2% § Daily change > 2% § New 10-day high § 5-day moving average > 20-day moving average § Price is above its 5-day moving average § Average daily volume > 50k § Relative volume > 1 § Price > 2 § Stop is the lows of the 2% breakout day Some examples of breakout setups: I am looking for stocks with established price momentum that are in a range contraction mode and are very likely to resume their uptrends. The bulk of the directional market moves tend to happen in just 10 – 15% of trading days. The rest is nothing more than noise in a range. I am looking for an event that is likely to signal the beginning of a new momentum leg. A 2% gain from the open to a new 10-day high is a significant move when it comes from an area of low-volume consolidation. Many range expansion trends begin with it. Another version of the breakout setup is to use 4% move without the 10-day high requirement. 4% is a significant move for most stocks priced above $10. Here we are looking to buy the low-volume pullback of a stock with established price momentum. A 4% move could be this signal. By waiting for a breakout, we optimize our capital allocation – we are making sure that we are invested only in names that are already moving in our direction. Or we could buy a trending stock in anticipation of a breakout, knowing that institutions are likely to support it. Anticipation Setu p Smart traders anticipate. Smarter traders know when it is Ok to anticipate. In some rare periods and specific situations, buying in anticipation of a breakout is fully justified. An anticipation setup has all the technical characteristics of the perfect setup. Previous uptrend, low volume consolidation, range contraction, the closing prices of the past couple or more days are very near to each other, etc. What else do you need to know about it? § It works only in strong up-trending markets, where most great setups eventually break out; § It allows to buy bigger position at more favorable price; § It might not trigger immediately; § Buying in anticipation takes more planning and effort than buying a breakout. You need to update on a daily basis a watch list of stocks likely to breakout; § You need to be aware of the strongest industries in the market at the time . In a strong, raging bull market, almost all stocks that meet our criteria for a perfect setup, will break out. The question is, do you want to buy them in anticipation and possibly wait a few days or do you want to buy stocks that are already breaking out today. It is a matter of liquidity and personal preference. Most good looking setups eventually break out in healthy markets and you could confidently afford to buy them in anticipation, get a better entry and make more money. If you wait for a breakout, you might miss them or have to enter at much higher price. Buying in anticipation requires a lot more than finding a perfect technical setup. There has to be something else, other than price going on for our stocks of interest – another catalyst like industry momentum or recent favorable reaction to better than expected earnings. We dive deeper into this subject in Chapter 3. Anticipating a breakout helps to get an early entry and can improve our risk to reward ratio. Anticipation setups don’t lower risk. Our risk is as much as we are willing to risk - as a percentage of our capital. Anticipation setups allow for tighter stops and therefore provide the opportunity to buy a larger number of shares while keeping the risk per capital the same. Let’s take a look at an example of a trade with Cheniere Energy (LNG). In an anticipation setup, we could enter at 75 and put our stop at 74. Our risk per share is $1. We enter with a tighter stop. The drawback is that we could be in too early and allocate capital to a non-performing asset. If we wait for a >2% breakout to new 10-day high, we could enter the same trade at 77 with a stop the low of the day at 75.50. In this case our risk per share is 1.50. We are paying the price of a wider stop for the benefit of entering a stock that is already moving . Since our overall capital at risk will be same, the only thing that would be different is the number of shares we could buy. Let’s assume that our risk per trade is $500. If we buy in anticipation, our position size will be 500 shares of LNG (the total risk of $500 per trade divided by our risk per share of $1). If we wait for a 2% breakout, we could afford to buy 333 shares of LNG as our risk per share is $1.50 If this trade works in our favor, the anticipation setup offers better risk/reward ratio. In this case, LNG went to 84, before it gave a sell signal and delivered a gain of $9 per share. The reward to risk ratio of this anticipation setup is 9:1. The reward to risk ratio of the 2% breakout setup is 6:1. This is a big difference. Safety Comes from Proper Timing We aim to capture part of a swing move, while diligently managing risk. Our position size is defined by our stop loss and the % of capital that we are willing to risk. If a stock gaps beyond our stop loss, our loss will be bigger than expected. To minimize the likelihood of this happening, we don’t hold a swing trade through events that could cause a substantial gap – earnings reports or FDA approvals. Safety is derived from proper entry, position sizing, stop loss and taking into account the current market environment . Proper entry is of crucial importance. Don’t chase stocks that are up 3-4 days in a row. Buy either in anticipation of a breakout or as a breakout is happening. A good entry point will put you at an immediate profit. These simple rules will save you a lot of money: § If there is no range contraction, don’t buy; § If a stock is already up 3-4 days in a row, don’t buy. Here are a few examples of extended setups, also known as “what not to buy gallery”: Why is it so important to look for stocks with recent consolidation or range contraction? 1. Such setups mean that stocks are under accumulation . 2. They allow for using tighter stops and therefore taking on a bigger position for the same amount of risk. We use stops: 1. Because we accept that we could be wrong. In fact, we know that depending on the market environment we could be wrong in 20% to 70% of our trades. 2. To protect our capital. We put our stops at levels that indicate that momentum is over and our initial thesis is proven wrong. 3. To keep our capital away from non-performing assets – such that go against us or consolidate through time without delivering proper reward. Risk/reward You will hear many traders say that we are looking for a trade that will deliver a reward at least 3 times as much as our risk. Of course, we do, but there is no way to know in advance what our actual reward will be. All we could do is strive to take setups that have the potential to deliver reward much bigger than our risk. We don’t actually know which trade will be successful and which won’t in advance. There is a way to substantially improve the odds of being right and we talk in detail about it in chapter 3 of this book . We control the setups we take, our stop loss and our position size. The size of our reward is defined by the market environment and our exit strategy. There is only one element out of the five I just mentioned that we don’t control – the market environment. We might not control it, but it is entirely our choice when to be active and when to be on the sidelines and protect capital. We dive deeper into this subject in Chapter 5, so keep reading. Bearish Swing Setups 95% of my trades are on the long side. During choppy, corrective markets, I rather to be mostly in cash and take a break from the market than push things on the short side. With that in mind, here is a screen I use to find short candidates. § Change from the open: Down > 2% § 20-day moving average below a declining 50-day moving average § 5-day moving average below 20-day moving average § Price is below its 5-day moving averag e § It is not down 3 days in a row § New 5-day lows § Shortable § Average daily volume > 200,000 shares § Price >5 § Not down more than 10% for the a week It is a plus if the general market is in a correction mode as defined by Russell 2000’s 5dma < its 20dma. It is not a requirement, because some ex-momentum leaders break down before major indexes are in a confirmed downtrend. Risk is 0.5% of Capital. We talk about position sizing in depth in Chapter 4. Stop is high of the entry day First exit: sell half when reward reaches 1X Risk (if you short a stock at $20 with a stop at 21, cover half at 19). Raise Stop to breakeven for the rest. Final exit: cover on extreme weakness or breach of downtrend, whichever comes first: Down 3 days in a row; cover at the end of the third day; When 7X reward is achieved On a breach of 5-day moving average If you are looking for anticipation short setups, keep a list of momentum stocks. They end up being amazing short candidates when they start to break down during corrections . Some examples of short swing setups: Chapter 2. When To Sell In Chapter 1, we talked about how to pick stocks, when to enter and where to put our stops. In this Chapter, we are going to cover how and where to take profits. If you don’t know why you are in a trade, you won’t know when you have to exit. Most stocks move in momentum bursts of 2 to 10 days. Then they enter into trendless consolidation through time or mean-revert. The goal of swing trading is to keep us invested in stocks that are moving quickly in our favor and avoid the so called “dead money periods”. In swing trading, we sell stocks on strength, 2 to 10 days after they trigger. Then we move to the next fresh breakouts. Selling 2 to 10 days after entry might sound too vague to many. Is it 2 or is it 10 days? It depends. There is a form of artistry behind it. Some of the factors that I take into consideration: - Sell on above the average volume wide-range day if the stock I own closes far from its daily high; - Sell if I need the money for a new setup that is just breaking out. If I am more than fully invested (margined out) and I see a setup that I like, I might sell some of my extended positions in order to enter a new stock. If you are having issues selling on strength If you have an issue selling on strength, you still need an objective signal that will indicate an end of the momentum burst you are riding. Two very practical such signals are: A daily close below the lowest point of the previous day: Piercing of a short-term moving average. It could be 5-day simple moving average or 10-day simple moving average. You could use exponential moving averages too, because they are faster and give more weight to the most recent days. All trading platforms offer those. A couple pointers to keep in mind when using moving averages as guidance: - The shorter the moving average, the more aggressive your approach is; - Small caps and lower priced stocks require faster moving averages like 5dma; - Large caps and higher priced stocks require slower moving averages like 10dma. Time Sto p If a setup triggers, but it doesn’t move more than 5% within 5 days, sell it and free capital for other ideas. Remember, the purpose of swing trading is to participate in the most explosive stage of a price cycle. Our goal is to avoid staying too long with stocks that are not moving in our favor. The pros and cons of partial profit taking If we are going after quick 2 to 10-day momentum bursts, should we take partial profits at all? Good question and the answer will depend on multiple factors, more important of which – experience, current market environment, risk affinity. Sell 1/3 to 1/2 of your position when we are up the amount of risk that you’ve taken. For example, if you bought 200 shares of AAPL at 100 with a stop at 98, you will sell half of them (100 shares) when it reaches 102 and raise your stop for the rest to your entry price of 100. We don’t know what exactly will happen after an entry signal is given. The setup could quickly reverse and stops us for a small loss. It could also deliver very small gain before it reverses. Taking partial profits helps to minimize the number of losing trades and allows us to have a risk-free ride with the rest of our position . The danger of raising stop to break-even after taking partial profits is that you are going to get stopped on a normal pullback and retest of a breakout. You don’t have to use partial exits. Partial exits will increase the success rate of your market approach, but they will decrease the overall return of your winners. Partial trades won’t guarantee better expectancy. Your trading cost will be higher, so you have to figure out for yourself what is a better exit strategy. In choppier markets, partial exits could save your head, but then why do you need to trade in choppier market at all. We will discuss this subject in the last chapter of this book. Taking partial profits will increase the success rate of your approach. The positive effect of having higher success rate is bigger confidence. You are building positive feedback loop that encourages discipline. The drawback is that we are missing on part of the profit, which hurts our overall return. It is a decision that you will have to make for yourself. For traders with less experience, taking partial profits is a must. For more experienced market participants, keeping full positions for 3 to 10 days might be the preferred way to go . Price Targets Exit target is whatever the 2 to 10 days horizon after an entry delivers. Exit targets depend on the market environment. The same setup that delivers 20% after a breakout in a bull market, could only deliver only 5% in a choppy market environment; Targets also depend on float, price, market cap. Smaller float (under 50 million shares), lower prices (under $10 stocks) and smaller market cap (under $200 million) tend to be a lot more volatile; therefore it is normal to expect from them larger moves. It is not unusual to see such stocks go up 20% to 50% within two weeks post breakout. A good example from August 2014 is Digital Ally (DGLY). It went from $4 to $33 in 10 trading days. Its float was 2.68 million shares. Its market cap before its big move was $10 million. Market cap = Shares Outstanding * Current Price Float = Shares Outstanding – Restricted Shares You could find information about them on any site with fundamental information: finviz, Google Finance, Yahoo Finance, YCharts, etc. Larger cap, higher priced stocks on the other hand are much slower movers. We will rarely see them have bigger than 8% to 15% swings before they consolidate in time or pull back. There should not be any seller’s remorse. In his book “Trading in the zone”, Mark Douglas says that “95% of the trading errors you are likely to make will stem from your attitudes about being wrong, losing money, missing out, and leaving money on the table – the four trading fears”. In any given year, professional swing traders take several hundred, maybe even more than a thousand swing trades. If you exit too early, because you sold on strength, know that there is always another one right around the corner. One trade does not matter. It won’t make or break your year or your month. Stocks move in short-term momentum burst of 5% to 50%, depending on their price, float, market cap and catalyst. The purpose of swing trading is to capture part of that move by risking very little, and then repeat the same process hundreds of times. You will be amazed how quickly a large number of small gains could compound your capital over time. Chapter 3. How To Be More Profitabl e In a low-correlation bull market, you will find more great long swing setups that you could possible take. Some would say that this is a good problem to have, but nevertheless it is a challenge that needs careful pondering - taking a full advantage of a favorable market is just as important as protecting capital during choppy markets. You need to have a system that will help you narrow down the universe of stocks you trade and substantially increase the likelihood of finding big short-term gainers. How do we approach this issue? We start by asking the next most logical question. What Makes A Stock Appreciate > 30% in a month? The catalysts are different. Some are fundamental (earnings), other are psychological (technical). Some could be predicted, others cannot. I found out that the majority of fast stock runners belong to one of the following eight groups: 1) Acquisitions – hard to predict and take advantage of. 2) Biotech stocks that receive FDA approvals – hard to predict and take advantage of. 3) Stocks of companies that receive a big order or they start running in expectations of a big order. Don’t forget that the market is usually forwardlooking and it often discounts events before they have happened . 4) Deeply oversold stocks that suddenly mean-revert - such setups coincide with a general market rally after a sizeable correction; 5) Stocks that crush earnings estimates by a wide margin. It is not the news or the size of the earnings surprise that matters, but market’s reaction. If you run your technical screens and don’t even care about the underlying catalysts, you will still find many of those stocks. Price is a catalyst on its own; 6) Stocks with very high relative strength that break out from continuation patterns; 7) Recent IPOs; 8) Stocks that belong to a currently hot industry. I have noticed that 70% of all stocks that experience big moves in short time frames belong to the last four groups. This is where I focus. There are a few other factors that impact the magnitude of the move, but they are of secondary importance: - Float. The smaller the float, the more volatile is likely to be the stock; - Market cap: the smaller market cap, the more volatile the stock ; - Short interest: the higher the short interest, the bigger the move potential. Industry Momentum One of the more popular Warren Buffett’s quotes states that “time is a friend of good businesses and an enemy of bad businesses”. When it comes to swing trading, it does not matter how much cash flow is a company generating and what its current valuation is. The main two factors that matter for swing trades, which could last anywhere between 2 and 10 days, are industry momentum and price setup. Price setups define the risk-to-reward and the probability of a breakout (breakdown) happening, but they don’t tell you the probability of followingthrough after a breakout and the likely size of the move. It does not matter how perfect is the technical setup that you or your software have recognized. If you are not in the right industry, you are poised to achieve inferior results as a swing trader. Industry momentum defines the likely magnitude of the move after a breakout (breakdown) and the probability of a breakout following through. Having an eye for industry momentum is among the most valuable skill a swing trader could learn . When looking for swing setups, the two most important factors to consider are: - Recent price volume dynamics: most swing setups consist of an uptrend move, followed by consolidation in the upper range of that move. Traders have come up with different names for them: flags, wedges, triangles… Keep in mind that finding the so-called flags and wedges is never a guarantee of success. It is not that easy. There is one very important factor that needs to be taken into account: the industry group; - Which industry group is currently hot? Stocks tend to move in groups. Being in the right technical setup in the right group could mean the difference between a 20% and a 5% after-breakout move; the difference between a failed breakout and a breakout with continuation. Bull markets are sustained by sector rotation. Every month or so, there are new industries that are leading. If you learn how to recognize them, your swing and position trading gains will improve substantially. Long time ago Keynes said that “the secret to market success is anticipating the anticipations of others”. It is easier said than done, but there is a way. There is a constant industry rotation going on in the market and if we keep our eyes open and keep our personal, irrational biases in check, we stand a chance of figuring out where money is flowing in real time. How do we recognize the industry we should be paying particular attention for our swing trades? It is not by ranking all industries by their 6-month relative strength. This is lazy and over-used approach that misses on many of the biggest movers. The most practical way is to pay attention the number of stocks from the same group that are up >4% for the day and clearing new 20-day highs or are setting up for a potential breakout. If several stocks from the same industry are simultaneously gaining momentum and having breakouts in short-term perspective, then the odds are that money is moving into that industry. What is the catalyst behind industry-wide moves? The reason behind the move is less important than the move itself. As the saying goes - it is not the news, but the reaction to news that matters. A lot better than expected earnings report by one company could be the catalyst for a major industry-wide move. It could be an acquisition in the industry or simply a side effect of a few forward-looking institutions that are buying in anticipation of good news. You could risk more on stocks with industry momentum. They are also perfect anticipation setups . When an experienced trader sees an industry gaining momentum, his (her) instinct is to look for the next stocks in the same industry to break out. After all, such approach makes all the sense in the world. If money is going to a certain industry, sooner rather than later it is likely to lift all “boats” inside that industry. By focusing on stocks that have not broken out yet and are still building beautiful technical bases, we could allocate money to more favorable risk- reward setups. Sounds logical, right? The curious thing here is that if you study the performance of industry-related moves, you will realize that in the majority of cases, stocks that break out first and attract our attention to an industry in the first place, end up outperforming substantially. Stocks move in groups, because institutions invest in themes. Industry-wide moves tend to surprise even the biggest optimists - they often last longer and deliver bigger returns than most expect. The leading industries are changing throughout the year. If you learn how to catch 3-4 of them, you will have a very good year. IPO s IPOs stand for Initial public offerings. They represent the first time a company offers its stock to the public. Once a company becomes public, then its shares could be traded on the secondary stock market, where everyone could buy and sell them. You will find incredible swing setups among recent IPOs. Because of their small float and Investment Banks’ support, they tend to move a lot in a short period of time. Recent IPOs could be among most lucrative trading vehicles in bull markets. If you would like to find setups that run 40-50% in a 1-3 weeks, keep a watch list of recent IPOs with tight bases. Here are some examples from 2014: TWTR, TOUR, ZEN, TRUE, TWOU, MBLY, GPRO. If you constantly study the stocks than gain more than 30% in a month, you will find many recent IPOs among them. There is a reason behind it. They have a lot going for them in a bull market: - institutional support; - insiders are locked and cannot sell; - float is small ,therefore even a little uptick in demand is enough to send shares higher quickly. If you want to understand why IPOs are among, if not the best, short-term trading vehicles in bull markets, you need to educate yourself on the concept of float and what it means for supply/demand dynamics. Float is the actual number of shares that is available to the general public . Float = Shares Outstanding - Restricted shares The number of outstanding shares is voted by the board of directors of each company. Restricted shares are owned by insiders: founders, management, employees, VCs. Companies always sell a minority stake during their IPO. You will notice that most newly public companies’ float is only 10 to 20% of their total shares outstanding. The difference is called restricted shares and it is owned by insiders, who are not allowed to sell for the next six to twelve months. This restriction is not created by the SEC, but by the underwriting investment banks. Google floated less than 20 million shares for its IPO in 2004. The rest became available 6 months after the IPO. Today, Google has a float of 620 million shares - it takes a lot more buying and selling power to move this ship. Microsoft’s float was only 20 million shares in 1986. Today, it is 7.6 billion shares. More recently, Twitter IPO-ed with 70 million shares out of 615 million shares outstanding . Small float, a bull market and a good story are an explosive combination of catalysts. When thousands of institutions compete to own a small number of stocks, we could see gigantic moves in short periods of time. This is where your focus could pay off big time during bull markets. These are not investments. These are swing trades. You have to organize yourself in order to gain from this approach. You have to do your homework and know which stocks could break out. I keep a watch list, dedicated only to recent IPOs. I constantly update it from the following link: http://www.nasdaq.com/markets/ipos/activity.aspx?tab=pricings It includes all new issues on the Nasdaq and NYSE. I pay special attention if an IPO belongs to a currently hot industry. It is not unusual to have more than 50 IPOs in a month. How could we keep our watch list of recent IPOs manageable? There are two main filters: volume and price. Fast moving new issues usually trade over 200k shares per day since the very first day. Many actually trade more than 500k shares a day. Such high volume signifies institutional interest. Then sort them through their price setup. We are looking for a breakout from a proper base that indicates the beginning of a momentum move. You could also buy in anticipation if an IPO belongs to a currently hot industry. The same swing entry, stop and exit rules apply here. The difference is that in a bull market, the returns that IPOs could deliver could be substantial. You could achieve substantial returns by focusing your trading efforts only on recent IPOs - stocks that IPO-ed in the past 6 months. They are some of the fastest moving trading vehicles. Granted, such form of specializing also comes with long periods of doing nothing, but you could use them to take a vacation and to mentally recharge. We talk more about this subject in the last chapter. Chapter 4. How To Manage Risk Position Sizing Position sizing is among the most important concepts in trading/investing. Its purpose is to define our risk in advance. Position size is defined by the risk we are willing to take. The bigger the percentage of our capital we are willing to risk, the bigger the position we will take. Position sizing might vary according to the market environment and the market cap of the stocks you want to trade. The following process describes the steps we need to take in order to determine how many shares we could afford to buy: 1) We start with the maximum % of capital that we are willing to risk. During bull markets, it is anywhere between 1% and 2%. During more volatile times, it is between 0.25% to 0.5%. For the purposes of this example, we will use 1% risk. 2) If our trading capital is 100k , then 1% risk means $1000 risk per idea. 3) Let’s assume that we want to buy a stock at $20 with a stop at $18. In this case, we risk $2 per share. 4) Then we need to divide the maximum capital we would risk per idea ($1000) over the money we risk per share ($2 in this case). 1000:2 = 500 shares is the size we could afford in this particular trade . 5) 500 shares * Trigger Price of $20 = $10,000, which in this case is 10% of current capital. Ten similar setups, taken at the same time would get us fully invested. If this particular trade goes against us and our stock declines below 18, the most we could lose (barring some unforeseen gap) is 1% of our capital. If it goes in our favor, to let’s say 25, our profit will be $5 per share or 2.5K from the entire trade, which amounts to 2.5% of the current capital. 2.5% addition to the overall capital is not a big contribution, but don’t forget that in swing trading we are looking to take several hundred one to ten days trades in a year. Returns could compound very quickly. Overall, the size of our positions depends on two main factors: 1) Our stops. The smaller the stop loss we use, the bigger our position size it will be. Using the example above, if our stop was at 19, instead of 18; then we would be risking one dollar per share, which would have allowed us to buy 1000:1 = 1000 shares. This is how we could have a 20% capital allocation, while risking only 1% of our capital. 2) The risk we are willing to take as a percentage of our capital. The smaller the risk, the smaller the position size. If we risk only 0.5% of our capital, then the maximum risk for us will be $500 per trade. Using the original example – if we buy a stock at $20 with a stop at 18, then we could afford to buy 500:2 = 250 shares. This amounts to 250*20 = $5000 allocation or 5% of total capital . You need to find the right combination of capital at risk and stop loss for you, depending on the market conditions and your personal risk preferences. The concept of Position sizing is of crucial importance for proper market timing, too. Successful swing traders do not only try to time overall market exposure (cash position), but also risk per setup. There are times that require being very selective and risking 0.25% of capital per trade. There are times that require being a lot more aggressive and risk 1% to 2% of capital in order to take advantage of short-term favorable market conditions. We cover extensively the subject of market timing in the last chapter. You could make 30% on a trade, but if you allocate only 5% of your capital to this trade, the overall contribution for your total capital will be only 0.3*0.05 =1.5%. It might seem low, but don’t forget that swing trading is high-turnover market approach. It requires taking hundreds of short-term setups in a year. None of them is going to make your year by itself, but combined they could deliver substantial returns. You can increase your profitability per trade by increasing your risk per trade. You just have to know when to do it. Everything comes with a price. If you risk 2% instead of 0.5% of your capital per trade, you will have more volatile moves in your account. Some people are not prepared psychologically to handle volatility and bigger drawdowns . In theory, you will increase your returns if you risk more and trade more. In practice, this will only happen if you get more aggressive during favorable market conditions, when your market approach has highly positive expectancy. If you get more active during choppy markets, you will be cut into pieces and you will lose more. Expectancy Expectancy is the average gain per every taken signal. Highly positive expectancy means that you have an edge. Expectancy = (% of winners * Average return of winners – % of losers * Average return of losers)*% of capital allocation You should be aware of the expectancy of your market approach. You could track that on your own by downloading your trades on Excel, Google spreadsheets or use specialized software like Tradervue. The most important things that you need to know about expectancy are that: 1) It tells you if you have an edge and how big it is. 2) It is not constant – it changes, depending on the market environment. 3) It is a rear-view mirror . 4) It could be predicted to a certain level of confidence, which is enough to be useful. Just like you don’t need to know the exact weight of someone to define her as overweight, you don’t need to know the future to figure out if your market approach has a significant edge or not in a specific market environment. Let’s take a look at a few examples: Let’s assume that no matter what the market environment is, we keep our losses to 6% on average and our capital allocation to 10% per trade. Capital allocation is defined by the stop we use and the percentage of capital at risk. For example, if we risk 1000 per trade and buy a stock at 20 with a stop at 19, we will be able to buy 1000:1 = 1000 shares of this particular stock or allocate 20,000 of our capital. If our current capital is 200k, this would be a 10% allocation. If our stop is at 19.50, then we would buy 1000:0.50 = 2000 shares, which is 40k allocation and 20% of capital. For the purposes of this example we will assume that each trade will receive an equal capital allocation of 10%. What would be the typical results of a swing trading approach in a healthy and in a choppy market? Healthy marke t In strong, up-trending markets, we are likely to have a much higher success rate and our average winners are likely to be bigger. Here’s what our expectancy would be with 70% success rate, average return on winners of 15%, average return on losers of -6% and capital allocation of 10% per trade. Expectancy = (0.7*0.15 – 0.3*0.06)*0.1 = 0.87% With a 10% capital allocation per signal, the average profit per every taken trade will be 0.87% of our capital. If we take 100 trades in this environment, our total return will be 87%. The actual return will actually be higher than that, because with the growth of capital our absolute capital allocation will increase too. Choppy Market The same approach that has very high success rate in healthy markets, could completely lose its edge in choppy markets. Here’s what our expectancy would be with 30% success rate, average return on winners of 10%, average return of losers of -6% and capital allocation of 10% per trade. Expectancy = (0.30*0.10 – 0.7*0.06)*0.1 = -0.12%. With 10% capital allocation, our average return per every single taken trade will be -0.12% of total capital. If we take 100 trades with this approach, we will lose 12% of your capital . The more active we are in this environment, the more money we are likely to lose. In this case, we basically have 4 options to help us mitigate the damage: 1) Trade less. 2) Use smaller position size (1/3 to 1/2 of your usual). Smaller position size means small capital allocation. 5% allocation for an approach with -1.2% expectancy leads to 0.06% loss of overall capital. 3) Sit on the sidelines in cash. 4) Use another approach that has a positive expectancy in this market environment. Some might make the valid argument that there is no way to know in advance when the expectancy of our approach is likely to turn negative or drop to a point, where we don’t have significant edge at all. This is not true. If you have been through several market cycles, you know that there are times when it pays to be aggressive and on margin and there are times to be mostly on the sidelines and in capital protection mode. In the next chapter, we are going to dive exactly into the subject of market timing . Chapter 5. How and Why To Time the Market Profitable swing trading requires market timing. The purpose of market timing is two-fold: 1) To limit drawdowns during unfavorable market conditions. A drawdown is the peak-to-trough percentage decline during a specific record period of an investment, fund or commodity. Minimizing drawdowns is not important only for capital protection and avoiding negative compounding. It also serves to protect our confidence and emotional well-being during choppy periods for our equity selection approach. 2) To figure out when to be aggressive and take on a bigger risk to take advantage of favorable market conditions. In strong bull markets, not only you could afford to be more aggressive and risk more per trade - you have to do it. These are the times that will make your year. These are the times that you could have a > 30% return in a month. Remember what Soros likes to say to his proteges - “it is not important whether I am right or wrong, but how much money I make when I am right and how much money I lose when I am wrong”. Nothing Works All The Tim e It is said that the definition of insanity is doing the same thing over and over again and expecting different results. The truth is that if you do the same thing over and over again in the market, you will get very different results, because the market environment constantly changes. The same type of swing setups that have 80% success rate and average 20% returns in a healthy bull market could have 30% success rate and 10% returns in a choppy market. The same market approach could have extremely positive or extremely negative expectancy, depending on the market environment. There are people who have no idea if the method they trade has an edge. Then, there are people who know when their approach is likely to disappoint, but they cannot help it. They cannot sit on their hands. You have to understand and track the expectancy of your market approach. If your system is right 50% of the time, but your average winner is 3 times bigger than your average loser, you have a system with positive expectancy. Having positive expectancy means that the more trades you make, the higher your return will be. One thing you have to realize about expectancy is that it is not constant. It changes depending on the market environment. A system with extremely high success rate and reward to risk in one market environment could have deeply negative expectancy in another market environment. This is the beauty of the market. No approach works all the time. If there was such an approach, sooner or later everyone would follow it and its edge would vanish. The True Nature of the Market The big difference between beating the market and struggling is not so much a question of superior equity selection (stock picking skills), but a question of market timing. The stock market is not a game, where for one party to win, another has to lose. It is a game, ruled by cycles - periods, when almost everyone is a winner followed by periods, when almost everyone is a loser. If you learn to distinguish between those two periods, you will achieve substantial returns. Everyone could make a lot of money during market rallies, when liquidity and performance chasing lift all boats and trump all bad news. Not everyone keeps that money when the inevitable correction comes. In volatile market conditions, most breakout and breakdown trades fail. Don’t get me wrong. Corrections are an important part of the market cycle. As legendary money manager, Peter Lynch once said : “It is not entirely clear what causes deep market corrections, but without them many of the best performing long-term investors would have never achieved their spectacular returns.” Those words were intended for long-term investors, but the same notion applies perfectly to swing and position traders. I have nothing against market corrections. I have a lot against giving back my profits during market corrections. Over time, I have learned to time my market exposure – there are periods, when I am barely invested and mostly in cash, followed by periods when I am very aggressive and using leverage to take advantage of a favorable market. The 80/20 Principle Today’s market has become very myopic. Investors want immediate results. No one has the patience to wait. As a result, most people jump from one strategy to another in a constant search of the holy grail that will make them money day in and day out. The truth is that the 80/20 principle also applies to trading and investing. 20% of your long-term investments will account for more than 80% of your gains. 20% of the trading days will account for over 80% of your trading gains . The market is really healthy only a few times a year for trading the perfect swing setup described in Chapter 1. Learn to recognize those periods and get aggressive during them. They are going to make your year. You could use the down times, to recover emotionally, to take some break. In Swing trading, it is equally important to: 1) Go to cash during choppy periods or at least decrease exposure substantially and use smaller position size. 2) Be aggressive and use leverage (larger position size) during favorable periods. We could only control our entries, exits, stop loss, position size and exposure. We cannot control the market environment. If you cannot control something, you adapt to it. How do we deal with choppy markets In an unfavorable market environment, you will find very few stocks that fit our criteria for a perfect setup. You will almost have to force trades in order to be active. Most setups look very sloppy in corrective markets. This is a side effect of the uptick in volatility. The necessary tightness in price range is almost nonexistent . Just because the indexes are under pressure during choppy markets, it does not mean that there won’t be long setups that will work. There will be some breakouts that will work, but if you take 20 of them, 12 are likely to fail and the rest will deliver subpar results. The same type of setup that has 75% success rate and returns 3xRisk in a healthy market could provide 35% success rate and return 1xRisk in a choppy market. We are not in the business of scalping for 1-2% while risking a similar amount. We want to get paid handsomely when we risk our money and dedicate our time. This is why knowing when to be active and when to lay low is of utmost importance. So how do we deal with unfavorable market conditions? We cut our risk per trade and we trade a lot less. If you risk on average 1% of capital and make 20 trades in a week, you cut your risk to 0.25% per trade and decrease your number of trades to 5 per week or maybe even to zero if you have to. You don’t limit drawdowns by only decreasing the risk of your trades. If you decrease your risk to 0.25% per signal, but you keep actively trading, you could still have a sizable drawdown. A drawdown is not the worst that could happen to you in a choppy market. Losing your confidence is far more dangerous . Why is it so important to decrease market exposure during corrections and even go to cash? You are not only protecting your capital, but also your emotional well-being and confidence. Being too active in a choppy market environment could condition you to adopt a lot of unhealthy trading habits. If you get too many hits (losing trades), even if they are small ones, you will start to subconsciously doubt your market approach. You will start to take quick tiny gains, because you would be afraid that the market will take them back. If you are too active during choppy periods, you are going to lose your confidence, because of the many losses you incur. When this happens, you are not going to be aggressive when it matters and when you really have to perform in order to make a difference. Once more healthy market environment presents itself (it always does), you won’t be in an emotional state to take a full advantage of it. The majority of your gains are supposed to come in this favorable market environment. You won’t be able to be active exactly when you have to. Don’t Be A Boom & Bust Trader Take a look at the equity curves of a typical trader, who does not pay attention to the market environment - the so called “boom & bust” trader and the one of a trader, who has learned when to be aggressive and when to step on the sidelines. When the market environment is not favorable for breakouts, Trader 1 (red line) goes to cash. He misses the initial move of a new rally, but for the simple reason that his drawdown was limited during choppy market periods, he ends up growing his capital a lot faster than a “Boom & Bust” trader. No one knows in advance which trade is going to work, but we could have a very good idea when we have an edge and when we don’t . I like to repeat that sometimes being wrong in the market is not a choice, but staying wrong always is. The truth is that more often than not being wrong in the market is a choice, kind of. If you know that your bread & butter setup does not deliver in certain market environment and that you are very likely to encounter a loss, don’t push it, don’t be more active. Many people know when their market approach is not likely to deliver good results, but most don’t have the discipline to step away and watch mostly from the sidelines. Being disciplined is a real market edge. How To Time The Market If you are going to dedicate capital to swing trading, it is of utmost importance to learn when to be aggressive and use leverage and when to protect your capital and even go to 100% cash. How do we know, when it is a good time to limit our market exposure and decrease position size? There isn’t a single indicator. It might sound like a cliché, but it is part art, part science. I use a combination of the following factors, listed in terms of relative importance : § What is the number of great risk/reward swing setups that show up on my scans? § How are those setups acting after they trigger? Do they follow up immediately and deliver hefty gains or do they stall and reverse? Every trade we take provides important information. If we notice that we are getting stopped a lot lately and that our breakouts are reversing, maybe the market is telling us to raise cash and decrease position size; § How are momentum leaders currently faring? They usually lead the market on the way up and on the way down. Every week, I post the SL50 list on SocialLeverage50.com. It features the current market leaders. The list will often start to outperform significantly the general market indexes like the S & P 500 and the Nasdaq Composite ahead of a widespread market rally. The SL50 list also tends to underperform substantially ahead of a widespread market correction; § Are the small cap index (Russell 2000, IWM ) and the Nasdaq Composite trading below their declining 20-day moving averages? Are their 5-day moving averages below their 20-day moving averages? If the answer to those questions is YES, we always reduce our market exposure by becoming more selective and risking less per setup ; § Has the number of distribution days in the major indexes risen recently? Distribution day is considered 1% daily loss on volume above the previous day’s volume; § Tops are triggered by excessive selling in a range-bound market. Bottoms are made from excessive buying near a flattening 5-day moving average. Most of the deepest selloffs start with a >3% down week in Russell 2000 (IWM). Most of the sustainable rallies start with a 3% up week in Russell 2000 (IWM) above a flat to rising 5dma. The 5/20-day moving averages indicator is the easiest to follow and it doesn’t require any proprietary readings. It has its limitations. It is a lagging indicator. In a choppy market, it will give a lot of false signals. It should be used alongside other indicators. It won’t take you out at the exact top and it will miss the initial stage of a new rally, but it will protect your capital from deep drawdowns and it will tell you when to be more aggressive. The positives far outweigh the negatives. I don’t say that the market cannot rally when Nasdaq Composite’s 5-day moving average (orange line) is trading under its 20-day moving average (blue line). Some of the most ferocious rallies happened during bear markets. It just means that this rally is not sustainable, it is not to be trusted and swing trading profits should be taken quickly. The 5/20 indicator doesn’t necessarily tell you when to be fully out of the market - this is a personal preference. It just tells you when to be on margin and when to have a sizable cash position or when it is ok to focus on short setups. Some traders prefer to always keep a few positions on, so they have a better feel of the market. Having a little skin in the game makes you a lot more alert. About the Author Ivaylo Ivanov (@ivanhoff ) is a full-time trader. He has been trading equities and options for almost ten years. He is the founder of Ivanhoff Capital, where he manages mainly his own and some family’s money. Ivaylo is Co-founder of socialleverage50.com , where he runs a stock-picking and risk management premium service. Mr. Ivanov is the author of The 5 Secrets To Highly Profitable Swing Trading and the editor of The StockTwits Edge - 40 Setups from Real Market Pros. Ivaylo’s work is regularly featured on Bloomberg, WSJ, Yahoo Finance, Reuters, CNN Money, UT San Diego, Traders Magazine, Abnormal Returns, Real Clear Markets, The Reformed Broker. Follow me on Twitter and StockTwits: @ivanhoff @SL50 ivanhoff.com socialleverage50.com sl-50.tumblr.co m Disclaimer The views expressed in this book are the personal views of the author only and do not necessarily reflect the views of the author’s employer. The views expressed reflect the current views of author as of the date hereof and the author does not undertake to advise you of any changes in the views expressed herein. In addition, the views expressed do not necessarily reflect the opinions of any investment professional at the author’s employer, and may not be reflected in the strategies and products that his employer offers. The author’s employer may have positions (long or short) or engage in securities transactions that are not consistent with the information and views expressed in this presentation. The author assumes no duty to, nor undertakes to update forward looking statements. No representation or warranty, express or implied, is made or given by or on behalf of the author, the author’s employer or any other person as to the accuracy and completeness or fairness of the information contained in this presentation and no responsibility or liability is accepted for any such information. By accepting this book, the recipient acknowledges its understanding. Copyright © 2014 by Ivaylo Ivanov All rights reserved. Limit of Liability/ Disclaimer of Warranty: While the publisher and the author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specially disclaim any implied warranties of merchantability or fitness for a particular purpose. No warranty may be created or extended by sales representatives or written sales materials. The advice and strategies contained herein may not be suitable for your situation. 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