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FIGURE 6.1 Erratic Revenue and Earnings: Lucent TechnologiesSource: Standard & Poor’s Stock Reports.
The dividend is normally paid quarterly to stockholders of recordon the declaration date. A dividend may vary from zero up to asignificant percentage. One method for selecting stocks is to seekhigher than average yields. This is one method for finding companies with healthy cash flow and profits. A corporation cannotpay out dividends unless it has funds available; so high-yieldingdividends among companies that meet other fundamental tests isan effective method for narrowing down your list.
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FIGURE 6.2 Consistent Revenue and Earnings: Wal-Mart Stores (WMT)Source: Standard & Poor’s Stock Reports.
Valuable ResourceTo find high-yielding stocks to invest in for periods longer than theusual swing-trading term, check Mergent Corporation’s DividendAchiever’s publications at http://www.dividendachievers.com orDogs of the Dow at http://www.dogsofthedow.com.
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dividendyieldthe profit earnedfrom dividendspaid by corporations, expressedas a percentage ofthe current price.For calculationpurposes, thepercentage shouldalways be basedon stock purchaseprice rather thancurrent price.
current yieldthe percentagepaid in dividends,calculating bydividing declareddividends bycurrent price ofthe stock.
cash flowthe cash availablefrom operationsto pay current andlong-term expenses and liabilities; fundbusiness expansion; and paydividends.
3. P/E ratio. The price-to-earnings ratio, or theP/E ratio, is a popular test of a company’scurrent price. It is a comparison of a technical factor (the current stock price) to a fundamental factor (earnings per share). Themultiple (the result of dividing price by earnings) is an expression of the market’s expectation for future growth. That is, the higherthe multiple, the greater the long-term risk.One selection method for stocks is to limitthe range of the P/E multiple. For example,you may decide to limit your stocks forswing trading to those with multiples between 11 and 25.4. Debt ratio. One of the most critical tests ofcorporate health is a study of the trend involving types of capitalization. A companymay fund its operations through equity capital (selling stock) or debt capital (issuingbonds or taking out long-term loans). Alldebt capital has to be repaid with interest, sothe higher the percentage of debt, the greaterthe strain on future cash. If debt capital istoo high, future expansion will be hampered,and as more profits have to be paid in interest there will be less remaining for dividends.So the debt ratio is one of the most important fundamental tests you can perform.To compute, divide the balance of long-termliabilities by total capitalization (long-term
Key PointThe P/E ratio should be viewed over a period of years and quarters to establish a trend. It compares current price to the latestreported earnings, so its interim reliability is questionable. Useyearend P/E to identify the actual trend and relationship between price and earnings.
Fundamental and Technical Indicators
debts plus shareholders’ equity), expressingthe result as a percentage. If this percentageis rising over time, that is a negative sign.Limiting the fundamentals is important because, with too much information, you cannotmake important distinctions between companies.A few solid, important tests that cover the questions of profitability and capital strength are adequate to pick stocks. The same argument applies totechnical indicators. In this realm, your goal isquite different, however. With the fundamentals,you seek signs of strength and consistent profits.On the technical side, you want stocks that are notwildly volatile, but are also not flat. The selectionof worthwhile technical indicators includes:
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P/E ratioa test comparingtechnical andfundamental information. The priceper share is divided by earningsper share to arriveat the multiple.The P/E is aneffective way tocompare stocksand to limit stockselection. Theresult of dividingprice per share byearnings per shareis expressed as asingle numericalvalue, known asthe multiple.
1. Trading range. The most basic of price indicators is the trading range. A very narrowtrading range, indicating low volatility, demultiplefines a stock as low risk; and a broad tradthe P/E of a stock,ing range, indicating high volatility, definesarrived at by divida stock as high risk. A stock that is soing price per shareby earnings pervolatile that no specific trading range canshare. The multibe found is extremely high risk.ple is expressed asa single numericalFor swing trading, you want to find stocksvalue.with moderate levels of volatility. If youequate volatility with interest in a stock,you can appreciate why moderate volatilitymakes sense. When both buyers and sellerscapitalizationthe total fundingare interested in the stock, a never-endingof an operation,struggle to control the price is expressedinclude equitythrough the two- to five-day cycles. Buyers(stock) and debt(bonds and longwant the price to move up after they buy,term loans).and sellers want to see price fall only afterthey sell. It is important to also recognizethat buyers become sellers, and vice versa, when price movementsuits an investor’s interests. If volatility is too low, this tells youthere is little interest in the stock; and if volatility is too high, it ismost difficult to decide the direction of the short-term pricecycles.
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PICKING STOCKS FOR SWING TRADINGKey PointThere is no need to exclude technical indicators just becauseyou look to the fundamentals. The most effective analysis usesboth sides to improve perspective on value, volatility and risk.
2. Direction of the channel. A price channel isthe parallel movement of the trading range.debt ratioIf you are going to open swing trades withthe portion oflong positions, you will be most interested incapitalizationstocks whose channels are moving upward.represented bydebt; to compute,If the channel is flat but trades can be madedivide long-termwithin that trading range, it does not matterliabilities by totalcapitalization,whether you open positions on long or shortexpressing thesides; you can begin with either, or use bothresult as adepending on the formation and setup patpercentage.terns that emerge.3. Recent history of short-term swing prices. Thehistorical volatility provides no guarantees offuture price direction. But it does providelong-termyou with some sense of how the price actsliabilitiesall liabilities dueand moves—the timing of up and downand payable bemovements, degree of change, and the imyond the next 12portance of changes in daily volume alongmonths (the current portion),with dramatic price movement.including notes,4. Recent patterns, including breakouts and pricecontracts andbonds.gaps. Technical patterns are interesting notonly because they provide buy or sell signals,but also because they allow you to anticipate the next move withsome assurance. Breakouts and price gaps are among the mostimportant technical indicators because they often are seen at thestart of a new trend. Even a minor price gap may signal a bigchange in direction, and price breakouts above resistance or below support are invariably significant. The stronger the breakoutpattern, the stronger the trend is likely to be. When breakout isaccompanied with one or more price gaps, it represents a verystrong short-term change in the price level. This is when swingtrading can be most profitable.
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Short-Term Versus Long-Term IndicatorsThere is a distinction every trader needs to make. This comes from coordinating the long-term fundamental and technical indicators with shortterm setup signals for swing trading. The two are so entirely differentthat the criteria cannot be ignored.You begin by determining which stocks to include in the realm ofswing trading possibilities. It may be that you will want to acquire andhold some of these stocks as well. This long-term determination must belimited because most people cannot afford to own thousands of stocks oreven hundreds. Acquiring shares of a few stocks must suffice, so you needto identify the criteria you are going to use as a starting point.The setup signals for swing trading can be found on hundreds ofstocks, indexes and exchange traded funds. This does not mean you willwant to try and make trades in a random and undisciplined manner.One dilemma for swing traders is deciding how to limit their range of activity. By first deciding how to pick stocks, you can achieve the necessarylimitations. Five guidelines to keep in mind:1. Apply basic fundamental and technical criteria. Earlier in this chapter, a handful of key indicators were provided with the purpose ofdemonstrating how you can limit the range of analysis in pickingstocks—both for long-term investing and swing trading. You maydiscover that the criteria for both are the same. Even if your intention is to swing trade and not to hold any stocks in your portfolio,your risk profile should always dominate the way you pick stocks,even if you intend to move in and out of positions in the typicaltwo- to five-day window. The criteria set limits on the range ofstocks you will use for swing trading. If you end up with approximately 15 to 20 stocks that you follow regularly and monitorfor swing trading opportunities—and all meet your analyticalcriteria—you will have your hands full. It is unlikely that you willever face a situation where no swing trading setups occur.Key PointThe goals you use for picking long-term investments are not thesame as that for picking stocks to swing trade. The same criteria,however, may be used to pick stocks that work for both purposes.
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2. Make value judgments about sectors of stocks. Every investor experiences a bias concerning groups of stocks. You might be fearful ofinvesting in sectors such as retail, oil and gas, or computers, forexample. These biases may be based on past experience or on asense of greater than average risk. Some sectors are clearly higherrisk than others in certain economic times. Whether your biasesare rational or not, you should avoid sectors that:a. You are uncomfortable with.b. You believe are high risk.c. Whose attributes you do not understand well.3. Focus on sector leaders. Within a particular sector, it makes senseto swing trade in the issues considered to be the leaders. There isa sound reason for this: The nonleading stocks in a sector tend tofollow the general direction of the leading stocks. For the purposes of swing trading, it makes sense to focus on those leaders toget clear setup signals. Some swing traders focus on sector indicesand funds, but this is less effective. When you trade an ETF forone sector, for example, you are trading a mix of all the stocks,both strong and weak; so the net result includes offsetting trends.It is more effective to trade in single stocks to make the most ofswing trading.4. Distinguish between speculation and swing trading activity. Thenpure speculative play is often a coin toss. Even speculators whouse various forms of analysis tend to favor undiscovered opportunities in smaller, emerging issues. Many of these companies havenever reported a profit and usually do not have a track record.They may also lack a clear trading range history. For that reason,important tests such as volatility, “typical” daily volume, and institutional holdings cannot be compared and tested. Swing trading is entirely different. The tendency in price patterns is moreeasily recognized among well established stocks, whose tradingrange is easily observed, and whose holdings include both institutional and retail investors. This does not mean you shouldn’tswing trade on speculative stocks. However, doing so simply involves more speculative risk, and that is an important distinction.5. Use appropriate trading modes. The majority of investors think interms of the traditional long position. The sequence of events
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is buy-hold-sell. But the short position—with the sequencesell-hold-buy—is equally important in short selling. In fact, onehalf of all short selling opportunities occur at the top of the twoto five-day cycle, when a sell setup occurs. So one choice is to enter positions only on the long side; another is to employ strategies that also enable you to swing trade by opening positionswhen stocks are expected to decline in price. There are two waysto achieve this:a. Short selling. First is by short selling the stock, which is a considerably higher-risk strategy than buying stock. Short sellingis explained in the next chapter.b. Options. The second way is by using put options. When youbuy a put, you profit if and when the stock’s price declines.Options can provide a valuable alternative to buying and selling shares of stock, and can vastly expand your potential profits from swing trading. Chapters 8 and 9 explain how optionscan be used in your swing trading program.
Price Volatility and the “Perfect” SwingTrade StockIn seeking the right stocks for swing trading, you face two goals, whichmay be contradictory. You need enough volatility to create the setups youneed to make those short-term moves in and out of the stock; in otherwords, you need to be able to trade on the emotions of other traders andto have those emotions. You also need to have some considerable marketinterest. At the same time, you do not want to take up positions in stocksthat are higher risk than you want to assume.
Key PointPicking the most appropriate volatility level for swing tradingdepends on both the trading range and degree of change. Trading range is the more important of these two.
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The “perfect” swing trade stock should contain a degree of volatilityadequate for those short-term price variations, but without the highvolatility you see with higher-risk stocks. Compare the one-year chartsfor two stocks, General Motors (GM) and Coca-Cola (KO). The first,General Motors, is shown in Figure 6.3In a one-year period, GM experienced nearly 100 percent volatilityin its stock price. (This is computed by dividing the difference betweenhigh and low prices, by the low price; in GM’s case, the 18 point spreadis divided by 18.5, the low, for volatility of 97 percent.) This price history is considered high risk by most technicians. Note also the threelong-term price channels, which during the year were all extreme in theirdirection. There were virtually no periods in which prices settled down.The trading range was continually about eight points wide.In comparison, Coca-Cola’s chart is far calmer. The one-year summary for the same period is shown in Figure 6.4.The price range in this case is only about five points, between 39and 44. Volatility is approximately 14 percent, far lower than the previous GM example. The price variation for Coca-Cola was adequate forswing trading, even though some other stocks’ volatility may have beenmore suitable for a high-volume swing trader.Candlestickchart.com© 2006 The RediNews Network
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FIGURE 6.3 Volatility: General MotorsSource: Candlestickchart.com.
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FIGURE 6.4 Calm Volatility: Coca-ColaSource: Candlestickchart.com.
A comparison between these two stocks makes the point thatvolatility in price defines appropriate stocks for swing trading. While youmay conclude that General Motors is higher risk than Coca-Cola, it doesnot always mean that swing trading is appropriate for one and not for theother. It is a matter of where your personal risk profile fits. If you are tooconservative, you will not be able to find any stocks for which swingtrading works; and if you seek aggressive price volatility, then you alsoneed to accept greater market risk.
Key PointThe stocks you pick for swing trading depend largely on yourperception of risk (especially when defined in degrees of volatility). What is appropriate depends on how much risk you are willing to take.
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For each person entering into a swing trading strategy, the definition of the “perfect” stock should rest with a study of price volatility andtrading range. For some, the five-point range for Coca-Cola would notbe great enough in terms of volatility. For others, the 18-point GeneralMotors trading range would be too high with 97 percent volatility. Ananalysis of many stocks will lead you to “medium-range” volatility stocks.This means averages of 20 to 40 percent volatility in a 12-month periodby some definitions. Given the extreme examples of General Motors andCoca-Cola, this assumed mid-range volatility is realistic.You will find volatility levels all over the place. A check of fourstocks covering the same year as General Motors and Coca-Cola revealedthe following trading ranges and volatility levels:Altria (MO)Citigroup (C)Merck (MRK)Pfizer (PFE)
62–8043–5126–4020–29
29%19%54%45%
Note that volatility levels and price ranges differ. An eight-pointrange for Citigroup in the 40s price level creates a 19 percent outcome;but virtually the same point spread, nine points for Pfizer in the 20s pricerange, represents a 45 percent volatility. This brings up an importantpoint of distinction between trading range and volatility. The actualvolatility cannot and should not be limited to the percentage computedon 12-month price spread. You also need to consider the point value inthe trading range. The General Motors 18-point trading range was quitehigh compared with the Coca-Cola five-point range, for example. Thiswould be true regardless of volatility percentages.
Key PointThe percentage of volatility is deceptive because its level depends on the price trading range. The breadth and point spreadof the trading range is a more reliable risk indicator.
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This observation works by making more volatile stocks appear lessso as well. Altria, for example, traded between 62 and 80 but reportedvolatility of only 29 percent. But its price range was 18 points, the sameas General Motors. In comparison, Pfizer’s nine-point range produced a45 percent volatility rate. These disparities are caused by the base pricelevels of each stock.In comparing price volatility between stocks, the formula for developing volatility percentages may be useful in some regards, but it can alsobe misleading. It makes more sense to compare volatility between stocksin terms of the actual trading range and the extremes of price channels.The next chapter takes the discussion into an analysis of short selling within a swing trading strategy. This is followed by two chapters explaining how you can use options to expand your strategy and bringflexibility into the program.
7Chapter
Selling ShortEntering a Swing Tradewith a Short Order
wing trading transactions can be entered withone of two timing beliefs: (1) the price isgo shortabout to rise or (2) the price is about to fall.a transactionIf you think the price will rise, you go long, meanbeginning withing buying the stock. If your timing is correct, thea sell order, tolater close withprice will rise and you can close the position at aan offsettingprofit. If you think the price is going to fall, thenbuy order.you need to go short, meaning opening the transaction with a sell order.In the series of transaction possibilities, thebuy to openlong position involves two well-known sides. Whenthe first order inyour order is defined as buy to open it means thea long position,first side of the transaction is long. And this posiwhich instructsthe broker totion is ended with an offsetting sell to close order.purchase theOn the short side, the orders occur in the opindicated securityand numberposite sequence. So the first transaction is calledof shares orsell to open, which simply means going short on thecontracts.security. This is closed with an offsetting buy toclose order.For many people not familiar with the concept of going short, this isa confusing idea. The question often is raised, “How can I sell something
S
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SELLING SHORT: ENTERING A SWING TRADE WITH A SHORT ORDERKey PointShort selling is simply the opposite of going long. The sequenceof short selling events is: sell-hold-buy.
sell to closean order thatcloses a longinvestment, whichinvolves sellingthe security andnumber of sharesto cancel out theopen position.
sell to openthe first order in ashort position,which instructsthe broker to sellthe indicatedsecurity and number of shares orcontracts.
buy to closean order thatcloses a shortinvestment, whichinvolves buyingthe security andnumber of sharesto cancel out theopen position.
I don’t own?” The answer is that when you go short,it obligates you to one of several future actions.These include (1) closing the position with a buyorder to cancel the short; or (2) in the case of options, accepting exercise by a buyer on the otherside. (There is more on this in the next chapter.)
The Reverse SequenceImagine going into the real estate market and finding a house for sale; finding a buyer and enteringinto a contract; selling that house to the buyer; andonly then buying the house from its current owner.Such action is difficult to comprehend and, infact, might even be illegal. In this example, youhave no legal right to sell the property or acceptmoney for it because you do not own it. But in thestock market, you can do just that, and as a swingtrader one half of the potential transactions youwill enter are going to be on the short side.This occurs because you are trading on theuptrend and downtrend of a stock, and dependingon the fear and greed of other investors. If you useonly the buy setup, you will capitalize on only onehalf of your opportunities, so going short is just asimportant to swing trading as going long. In thenext chapter, you will see why shorting the stockmay not always be necessary; however, to make thatdecision for yourself, you need to first review howshort selling works, identify the risks that are involved, and determine whether short selling isappropriate for you.
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Key PointSelling something you don’t own is not allowed in most circumstances. The stock market is one exception; it is simply a matterof the sequence of events being different.
Here is how the procedure works. To sell a stock short, you firstneed to borrow the stock. So if you want to short 100 shares, your brokerage firm buys those shares in your behalf. You sell the borrowed shareson the market. If the swing trade is well timed, the stock’s value will falland you can close out the position at a profit. If your timing is off andthe stock price rises, you need to either sell at a loss or wait out the timing of the price trend. This could lead to problems if your read of thechart was wrong, which will certainly happen sometimes.For example, in Figure 7.1, a six-month chart for Walgreen Company is shown. There were numerous points in this period when thesetup appeared indicating the stock was likely to fall; and yet momentumcontinued to carry the stock upward.Candlestickchart.com© 2006 The RediNews Network48.1547.2546.3545.4544.5543.6542.7541.8540.9540.05
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SELLING SHORT: ENTERING A SWING TRADE WITH A SHORT ORDERKey PointRegardless of how you enter a swing trade, it ideally takes onlyfive days at most to close up. Beyond that, it might be wise tocut losses and leave the transaction.
In this case, selling short could have resulted in a loss. From the beginning of the period to its end, the stock rose eight points. The setupsignals are not always clear and you cannot expect a 100 percent successrate from swing trading. While the false signal may occur only a smallportion of the time, this illustration makes the point that short sellingdoes involve risk.Some traders will accept the risk of short selling, recognizing thatusing confirmation indicators, it is possible to avoid losses most of thetime, or minimize them by curtailing the activity. Remembering thatswing trading is designed to complete opening and closing transactionwithin five days or less, it makes sense to cut losses when they do occur.The other procedural aspect to short selling involves borrowing thestock in order to sell it. This involves a cost. Your brokerage firm chargesinterest based on the value of the borrowed stock, the holding period,and its current interest rate. Based on the minimal rule in effect for margin borrowing, you are required to deposit at least 50 percent of thestock’s value. If the value rises, your brokerage firm will require additional sums to be left on deposit to cover this margin requirement. The outstanding borrowed stockremains subject to interest payments and marginuptick rulea Securities andrequirements until the short position is covered,Exchange Commeaning shares are bought to close the position.mission (SEC) ruleIn addition to the margin requirement, shortlimiting shortselling activity toselling is also somewhat restricted by federal rules.prevent priceThe uptick rule was introduced as part of the Secumanipulation;stock can berities Exchange Act of 1934 and is known as Rulesold short only10a-1. It states that you can only sell stock short onwhen the latestan uptick or a zero-plus tick. In other words, youtrade was higherthan the tradecan only enter a short sell if the last traded pricepreceding it.was higher than the one preceding it. The purpose
Risks of Short Selling
of this rule was to prevent short sellers from placingdownward price pressure on the stock simply byselling short, which would create greater profitswith higher levels of short selling. So when you enter a short sale order, you know that the order willbe filled only if and when an uptick occurs in thestock.
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zero-plus tickprice movementof a stock whenprice rises at leastin its minimumincrement in thelatest trade.
Risks of Short SellingShort selling, also called “shorting” a stock, is designed to create profitswhen your timing is correct and the stock’s price falls. Most people aremore familiar with the concept of going long or buying a stock in thehope that its market value will rise. While short selling may be just asprofitable as buying shares of stock, the transaction is far more complexand involves considerably greater risks than long positions.With these risks in mind, some swing traders prefer to avoid shortselling and focus only on looking for the buy setup. This is a more conservative approach than using both long and short opening positions. Ineither event, the margin requirement states that at least 50 percent of thestock’s value must be deposited with your brokerage firm. However, riskon the short side is in theory unlimited (the stock could conceivably risein value indefinitely) whereas long-side risk is limited. The ultimate losswould be held to the amount of money invested, assuming the stock’smarket value could fall to zero. A more realistic point of view, however,would curtail potential long-side risk even more, to tangible book value.For example, a stock sells today at $55 per share. A short sale hasunknown risks because that stock’s price per share could rise indefinitely.The maximum long-side risk is $55 per share; but tangible book value is$20, so a realistic maximum risk is $35 per share.
Key PointLooked at in the isolation of short selling, going short on stockis equal with going long. But in practice, risks are far higher.
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Risk comparisons are difficult to make for swing trading. In theory,at least, the swing trading market risk is identical on both the uptrendand downtrend. As long as setup strength is identical on either side, youdo not care whether the stock price is a reaction to fear or greed; the timing strategy remains the same. However, once you begin working withinthe position itself—going long or short in the stock—the risk picturechanges dramatically. Short selling stock involves far greater risks thanbuying shares.Short selling is not accurately viewed as being “equal” to long positions as part of a swing trading strategy, given these differences in risklevels. Short selling is often used by investors as part of a broader strategyor hedge, one of many strategies in which a positionis taken to offset risk in a different position. For example, if you own stock and the price moves uphedgesignificantly, you might sell stock short to profita position takenfrom a short-term correction, but without havingin a security tooffset or eliminateto sell shares you are holding long. Short selling ofrisks in anotherstock is also used to offset positions by optionsposition. Fortraders and is used for numerous reasons by hedgeexample, goingshort may befunds.used as a way toThe risk is each side to the strategy also has toprotect paperprofits in longbe viewed by swing traders regarding dividend inpositions.come. A short seller never receives a dividend; although that represents a potentially importantportion of overall gain. In comparison, when you are in a long position,you do earn dividends as long as you own the stock on or before exdividend date. One variation on swing trading may involve the tradingof shares with this ex-date in mind, given the adjustment made to stockprice value once dividends are accounted for. For