Swing Trading: Power strategies to cut risk and boost profits, by Jon Markman

I got excited about this book not from the first chapter, but the second. That is when the author started discussing a trading style that matched my own. Before I get to that, let’s talk about the book. Each chapter covers a different trader: Terry Bedford. Bert Dohmen. George Fontanills. Jon Markman (the author), Richard Rhodes. and Phil Erlanger. In that sense, it is a lot like the book, Market Wizards.

As a writer and author, I am prone to spot spelling and grammar errors when a normal person would not. This book should get a new proofreader. There are the factual mistakes, too, like using limit order when he means stop order (page 78), referring to a head-and-shoulders top when he means bottom (page 56), and I chuckled at IBM announced it had built the ‘world’s fastest transitory’ (page 52). I have never heard of a transitory, but I played with transistors when I was young and as a hardware design engineer. For all I know, maybe IBM did invent the transitory. I mention all of this because Markman is/was a columnist for CNBC on MSN Money and TheStreet.com, according to the back book cover.

Despite these flaws, I consider this book a good one. The writing style is breezy and engaging, as you would expect from a seasoned writer.

Let’s talk about the chapters, now, and what I consider important lessons from each one.

Terry Bedford

Terry Bedford is a chart pattern trader, but he uses more than chart patterns. On page 15, Markman discusses Bedford’s use of volume. When stocks rally to new highs amid slow and progressively weak volume, technicians argue that they enter the distribution phase — the phase where the smart money begins selling profitable long positions, amid continued good news.

He adds, Beware weak volume rallies amid good news. For the bearish side, Markman writes, When stocks decline to new lows amid slow or progressively weak volume, swing traders should note that they enter the ‘accumulation’ phase — the phase where the smart money begins adding new positions for longer-term gains. You need to be very careful about shorting into weak volume declines amid bad news. He adds to this thinking on page 21. When volume contracts after an extended rally, or expands sharply after an extended decline, a dramatic reversal will normally transpire.

One item about chart patterns got me to thinking about throwbacks and performance. On page 36, Markman writes, Upside breakouts through the reaction high often lead to small two percent to three percent advances followed by an immediate test of the breakout level. If the stock closes below this level (now support) for any reason, the pattern becomes invalid.

In other words, he says that if price during a throwback drops too far into the pattern then the pattern is invalid. I do not agree with that assessment, but I will conduct research to prove or disprove his statement (see ThrowPull.html ). If he is right, then it would make trading patterns easier. Just placing a stop at the top of the pattern may save you a bundle of money when price breaks down and continues lower. Instead of placing a volatility stop 8%, 10% or 15% below the purchase price, you can use the top of the pattern as the stop location. A breakout on good momentum will not have price throwback (or if one occurs, the plunge should be shallow). And that can save you money. My guess is that this will get you out of some fabulous trades — the big winners — but that is the way it goes. If this rule can change a 15% loss into a 3% loss, then maybe it is worth missing out on a 30% move. Maybe.

Another sentence in the book got me excited, too: Patterns with extended right shoulders should be avoided. He mentions this on page 46 when discussing head-and-shoulders tops. I tested this and found that he is right. I have always preferred symmetrical patterns to ones that look unbalanced. Then again, some ugly patterns tend to work better. I have proven that but only for double tops and bottoms.

Bert Dohmen

Having finished the book, I think the title of this one should have been Position Trading and not Swing Trading. By my definition, a swing trade is from minor low to minor high, or the reverse, minor high to low. A position trade is almost buy-and-hold. You catch the trend and surf it until the trend ends. A position trade can have a dozen swing trades.

Bert is a position trader, just as I am. Markman writes that, Dohmen loves to buy stocks making new highs, particularly if they are all-time highs with no overhead resistance from a high 3, 5, or 10 years back. If you buy new highs, he points out, you don’t need to worry about moving averages, stochastics, or other indicators. ‘If you are looking for strength, buy the strongest stocks in the strongest sectors. If you are looking for stocks to short, sell the weakest stocks in the weakest sectors.’

Once Dohmen finds a stock he likes, he buys at the market without waiting for a pullback (retrace of the uptrend). I see so many people concentrate on nickels and dimes. They see a breakout in price and volume and wait for a pullback — but that’s a big mistake. He will add to a position using a pullback to support, but he avoids buying into pullback situations in which the industry sector is moving sideways or trending down.

Another caution Dohmen notes is that if a stock is within 15% of a high over the last 3-5 years, he will wait for the stock to top that high before buying. If the one-year high is 20% to 50% below the 3-5 year high, he will enter and likely exit the trade before overhead supply setup by those prior peaks causes selling pressure. He also avoids stocks that breakout in an industry that is not trending in the same direction as the stock he wants to buy.

He places the initial stop just below the prior day’s low, reasoning that if the breakout setup is proper, upward momentum will carry the stock higher immediately. Any retrace that would hit the stop suggests a weak situation. Once the stock has moved higher, he transitions to a 10% to 12% mental stop below each day’s close, below a 21- or 50-day moving average, or below a trendline.

To add to a position or buy into a new position, Dohmen uses a 38% to 62% Fibonacci retracement of the prior up move, confirmed with another indicator such as a bullish candlestick or strong reversal of the retrace on high volume.

He uses trendlines at least 2-months long to help time his exit (connecting the lows and not the closes, by the way). Once he sees a trendline violation, he will search for confirmation of the exit signal. Unfortunately the text does not describe what those confirmation signals are, only that trendlines with lows spaced far apart are more important than those closer together and that he always obeys a trendline violation.

When buying into a position, he scales into it, buying the largest chunk on the first trade, using pullbacks to buy more, each successively smaller chunk than the prior entry. He avoids building positions with larger and larger chunks because that raises the average price too far, increasing the risk of a failed trade.

His portfolio consists of 10 to 20 diversified positions with no more than 5% in any one stock, split between 3 or 4 industries when the general market is trending upward, but will stay in cash when necessary (like when he goes on vacation). For a $100,000 portfolio, he would start the first entry into a stock by spending $2,500 and additional buys to total no more than $5,000 (combined). The stocks you feel strongest about are the ones that come back to bite you, and that is something I have found to be true. Many times I have added to a position because I was sure it was going to work out, only to find I was wrong. I added to a position as it tumbled and sold near the low for a larger loss because I was sure it would turn upward, that the decline was just a retrace of the uptrend. The turn did come, but by that time, I was no longer in the stock.

George Fontanills

George is looking to find momentum plays, using high-beta stocks in the news with lots of institutional interest. He is looking for longer term plays and has 6 rules to help locate movers that will transcend a one-day move into a longer-term one.

1. Volume is at least 300,000 shares and price is up or down 30% in one day or
2. Volume is at least 1 million shares with a 20% price change from the prior day or
3. Volume is at least 1 million shares and price is changed by $5 per share in one day and
4. The stock is trading at more than $7 per share and
5. The stock is optionable, and finally
6. It has a long-term story behind the news, like an accounting scandal (something that is likely to last several quarters, contrasted with an earnings shortfall that may last one quarter)

Markman tested the first rule and says he found that 49% of the 564 stocks qualifying closed lower. A month later 54% were down by a median 4%, 69% were lower 6 months later by a median of 23.3%, and 76% were lower 12 months later by 51.5%. The test used data from March 2000 to August 2002, a bear market when almost anything was dropping.

To take advantage of these long-term events, Fontanills waits a few days for a mild rebound then buys out-of-the money put options with expirations 3 to 12 months later, preferably in a stock that regularly shows intraday high-low swings of $2 per share. He says that CNBC is one of the best catalyst creators. We pay attention to what they’re pounding on, like Tyco, Tyco, Tyco eight times a day! That’s a signal that it’s one to start playing, it makes a great trade — because ultimately people aren’t sophisticated in trading will start to take the other side, and you can take their money.

Once he is into a trade, he will sell half his position after it doubles, holding the rest until momentum drops off or even reverses.

Jon Markman

At first I thought it unusual to have a chapter in which you were the star, but why not discuss your trading style? That’s what Markman does. He took his idea for a stock screening program to Camelback Research Alliance and they developed the StockScouter rating system/program used at MSN Money. He discusses how it works in general and specific terms, which I found surprising (meaning I liked what I read, but it is still a black box to a degree). Since the discussion covers many pages, I won’t repeat it here. Besides, you need a reason to buy this book (and remember to buy it through this website, too, because it helps protect endangered species like myself. It does not add to your cost, either. A win-win situation!).

Markman then discusses his HiMARQ analysis technique, which stands for historical monthly average return quotient. He builds a spreadsheet and walks you through how it’s done. The intent of the spreadsheet is to locate stocks that will outperform in the coming month, either very well or very poorly, whereas StockScouter looks for longer-term plays (1 to 6 months out). He writes that HiMARQ analysis is most useful in the extremes. If a stock has been up 6 times in the past 10 Marches and down 4 times, no useful information is imparted. But if a stock’s been up 9 times in the past 10 Marches, and down just once, it’s fair to bet it’ll be up the next March, all other things being equal.

Richard Rhodes

According to Markman, Rhodes has a list of 18 rules such that if you follow each one, you will make money every year. Here is the list and you can decide for yourself.

1. Trade from the long side in a bull market.
2. Buy strength; sell weakness. The theme here is to buy high and sell higher, profiting on upward momentum. Trying to buy low and sell high should be left to the amateurs.
3. Only enter trades that are well thought out, ones with stops and additional buys mapped out.
4. Add to a position when price retraces a portion of the major trend.
5. Have patience. If you miss a trade, another will come along or wait for a retrace to a support zone before entering.
6. Be patient. Do not be afraid to stick to a winning trade. Those are the ones that will make the big money.
7. Be patient. Give enough time for a trade to work.
8. Be patient. The real money is made from the one, two, or three large trades that develop each year.
9. Be impatient. Cut losses short. Do not allow them to grow into large losses.
10. Do not average down. Never add to a losing position to lower the average cost.
11. Emphasize what works and eliminate that which does not work from your trading style. Add to positions that are working well and sell those that are lagging behind.
12. The fundamentals and technicals must agree before trading. This will give you confidence to stay with a promising trade.
13. Stop trading when you suffer sharp or recurring losses. I would switch to paper trading and only go live when your trading style begins to work again.
14. Trade more (larger positions) when you are doing well. Reduce position size when things go against you.
15. Only add 1/4 to 1/2 of a full position when adding to an existing trade. You are averaging up but in a modest way, so if the trend reverses, you will not be badly hurt.
16. Trade with the trend (Markman puts it as Think like a guerrilla warrior. Fight on the side of the market that is winning. If neither side is winning, then don’t fight at all).
17. Market form their tops in violence; markets form their lows in quiet conditions.
18. The last 10% of the move requires 50% or more of the time. The first 90% of the trade will require half the time and be difficult to trade.

To evaluate the environment for stocks, Rhodes looks at various websites. For the U.S. he likes to read the Dismal Scientist. He watches the strength of the dollar because, a strong dollar brings strong investment flows into the United States, which finance our bonds and support our stocks. Investors generally prefer a strong dollar. Ten year treasury notes, 5-year and 2-year T-bills point the way to the health of the economy. When interest rates are high but coming down, the decline has the highest effect on businesses and consumers. People start to buy homes, cars, and big-ticket items. For companies, the cost of doing business declines and they can invest in new projects.

Of course, to find out about what the governors of the FED are up do, visit their site at the Federal Reserve and tell them Tom sent you.

For Europe, Rhodes looks at the euro. A strong euro is good; a weak one is bad. To monitor the action, he visits the European Central Bank because, according to Markham, The lowered rates allow business investment to flood in much more quickly than a similar move in the United States. If it is dropping rates, it is supplying liquidity to the market and national banks will lend money in greater amounts to businesses, which will then begin to make more stuff for export.

The Bank of England and the Bank of International Settlements he reads to get a better sense of the European economic environment. Apparently, those two sites produce a prodigious amount of reading material.

For trading setups, Rhodes favors an outside day or week with price pegged at the end of the bar opposite the trend. An outside day/week is when price of the current bar has a higher high and lower low than the prior bar. Price is outside the trading range of the prior bar. When price is trending up and the stock closes at the bottom of the outside day/week or price is trending down and the stock closes at the high, it is a reversal pattern that I will trade on it with almost blind faith, Rhodes says.

He also trades at the market when he get a buy or sell signal.

Phil Erlanger

Erlanger studied short selling and short interest ratios. He found that a stock in a multi-month decline would show short interest reaching a peak and then plateauing, and that often signaled that the stock was near bottom. The stock would rally and the short interest would plummet. Whenever there was a big jump in short interest, it would not signal the exact low — but the greatest part of the decline would end when short selling got to extremely high levels, he says.

On page 281 of the book, Markman shows 10 small charts of price versus a market index (just what index is used is not disclosed). It is a chart of relative strength. The charts come with the probability that the next move will be up. The scales on the charts are not identified, so you will have to guess as to what they mean. Erlanger likes relative strength so much that if stranded on a desert island with the choice of keeping any one indicator, it would be relative strength.

On page 291, Markman writes an interesting observation: The market tends to move against the majority at risk. I will leave you with that thought.