Compared to buy-and-hold approaches, trading stocks for short-term gains demands excellent discipline and a high tolerance for risk. Viewed over short periods, stock prices alternate between upward and downward movements referred to as “swings” that appear erratic and largely unpredictable. A stock that has large swings is considered volatile, an unsettling quality for most long-term investors. However, swing traders rely on a stock's volatility to successfully earn their short-term gains, though they also must master the potent emotions that accompany volatile positions.
Crowd-Think and Emotional Trading
Many economists and traders describe the chaotic short-term movement of stocks as the "random walk" hypothesis, which suggests that short-term price movements are no more predictable than random chance. They also suggest that price volatility is in part due to strong emotions -- primarily greed and fear -- experienced by all traders; investors who notice a rising stock tend to buy it too late out of greed and alternatively sell a stock too soon because they fear losses and can't withstand the uncertainty of their volatile position. This behavior is called “crowd think,” and it's a real danger even for experienced investors.
Developing a Trading System
To overcome emotional trading, professional and experienced investors develop trading systems. A system allows you to enter and exit positions mechanically, rather than emotionally, but it requires a strong discipline as its glue. While a variety of approaches exist for developing trading systems, many swing traders begin by using a custom stock screener -- software that searches for and locates stocks based on specific fundamental or technical criteria. From this group of stocks, traders create rules that describe when to enter and exit positions. The last step is to test the system of rules, either against historical market data or through simulated trades in actual market conditions.
Trading Both Upward and Downward Swings
Trading stocks for short-term gains requires that a trader understand how to successfully trade a stock regardless of its direction. Going long means to buy a stock with the goal of selling it after the price has risen, but short-term traders also profit from downward movements by going short. Often called short selling, going short involves selling a stock you don't own. To do this, you borrow shares from someone else -- typically your brokerage house -- to sell, hoping to later buy replacement shares when the share price has decreased. Profit is earned from the difference between the high price at which you first sold the borrowed shares and the lower price at which you later buy them back.
Overbought and Oversold Conditions
When demand pushes a stock's price high enough, traders who entered positions earlier begin to take profits by selling, and strength in the stock weakens until it can no longer maintain the inflated price. At this point, a stock may be considered overbought, and swing traders take short positions to profit on the coming downward movement. The opposite to this finds the stock oversold, and swing traders reverse their positions by going long to profit on the upward movement. Through good timing and by taking an appropriate position, it is possible to make short-term gains from a stock's movement in either direction.
- A Random Walk Down Wall Street; Burton G. Malkiel
- Getting Started in Swing Trading; Michael C. Thomsett
A Florida native, Doug Wetzel has a background in both finance and technology ranging from investment banking to CTO and director of research and development for a NASDAQ company. Since 1994, Wetzel has also been a technical writer, authoring white papers such as DCTI's "Credit Card Fraud," and Web articles for AnswerBag and eHow.