I have precise reasons for taking trades, and precise reasons for not taking a trade. When it comes to taking long swing trades, these are things that tell me to stay away.
First a bit of background.
I swing trade stocks as a trend trader. That means I am only going to buy stocks in an uptrend or that are showing signs of uptrending behavior after a pullback in price. Uptrend behavior is making new swing highs and swing lows.
Many stocks are in uptrends at a given time. Not all are worth trading. Here are three things that tell me to stay away.
Reasons Not to Buy a Stock #1: Bigger Percentage Drops Than in the Past
As a stock rises, especially in the early stages, it sets a precedent for future declines. If a stock is dropping between 10% and 15% and then rallying to new highs, if it suddenly drops 30% something has significantly changed. It doesn’t mean the stock can’t go higher, but more often than not (at least in the stocks I am scanning for and watching) that bigger drop means the stock will move sideways, have choppy price action, or drop over the ensuing few months. In other words, the big uptrend is likely to take a pause for a while.
Since I want quick profits and explosive action to the uspide, bigger drops than normal mean I won’t likely be taking a swing trade in that stock any time soon.
Here’s an example of how this looks on a chart.
DOCU was a very strong stock through 2020. It trended well at times and also gave clear signs for when to stay out.
Through late 2019 the drops were typically about 10%. The 17% drop was a warning sign. The stock fell significantly and for some time after that. The stock rebounds (uptrending behavior) and the price action gets tighter again (drops get small again). As the price starts rising and drops get smaller, I can start trading the stock on the long side again.
In mid-2020 the same thing happens. A big drops tells us to stay out. And no new uptrend develops after.
The dynamic of the stock has changed. It is no longer easy money with small pullbacks and big rallies. Instead, it is big pullbacks and similar-sized rallies (or worse yet, smaller rallies and bigger drops). Which also means no uptrend.
The same concept applies to the size of a pattern (which is created by the size of the drops).
If prior triangle patterns were formed within an initial 20% drop or so (small or slightly larger). A pattern formed by a 40% drop is of no interest to me, unless the price can rally higher and start forming patterns out of smaller drops again.
If a trend channel has been dropping approximately 10% and rallying 15%, a 20% drop changes that whole dynamic. I’m not trading that stock for a while.
I always use log charts for trending stocks, since the price can cover a large price area. A log chart makes similar percentage moves look the same regardless of price (an arithmetic chart doesn’t). This makes it easier to see (without measuring every wave) if a current drop is much bigger than prior drops.
Reasons Not to Buy a Stock #2: Choppy Small Waves Higher
I’m not a fan of holding through a lot of pullbacks. I like being in for quick bursts to the upside and then getting out. Holding through one pullback or a bit of sideways movement is bound ot happen on many trades, but I want my 20%+ gains relatively quickly.
Choppy small price waves don’t usually produce quick gains.
For example, check out the chart below. At a glance, it actually looks great. A steady climber…great for an investor…not for me, despite the impressive overall gains.
I don’t hold swing trades through earnings, so I need my burst of momentum to occur between earnings.
Looking at price patterns in the past, loosely based on patterns I may consider trading, the stock tends to only rise a 5% to 12% before leveling off, pulling back, or an earnings announcement. Unless I have absolutely nothing else to trade, I would way rather trade stocks that tend to jump 20% or 30%+ and then level off, compared to a stock that only moves 10% at a time.
Nothing wrong with this stock, it just doesn’t suit my style. Too choppy. It just kind of grinds higher.
So I stay away. I can find much better bang for my swing trading dollars someplace else.
If a stock like this is moving in a trend channel, and I can get in near lows as the price transitions higher, then maybe I would trade something like this. Yet the swings to the upside still have to be big enough (or very quick if under 15%) for it to be worth my while.
Reasons Not to Buy a Stock #3: Low Reward/Risk Based on Typical Price Moves
In the section above I looked at how far the price typically runs out of a contraction pattern (you should measure waves based on your own strategy entry point).
On a stock like that, at the top end I could expect to make about 20%. More likely in the 5% to 10% range.
Let’s say I am ok with that. And I set a target at 10% above my entry. I define an entry and see that I need to place a stop loss at least 5% below my entry to avoid the choppy price action of the stock.
Hmmm, I am risking 5% to make 10%. This is only 2x my risk, in a choppy stock that sometimes only moves up 5% after forming a contraction pattern (even if it’s not a great one).
I only take trades where I reasonably expect to make AT LEAST 3x my risk, based on how the stock actually moves.
The following stock tends to have much bigger runs higher. While I have no idea if this stock will produce another big run, based on the price action, expecting a 20%+ run/profit target is reasonable. Find an entry point with a 4% or 5% stop loss, and that is a 5:1 or 4:1 reward/risk, and potentially much more if using a larger target which would still be within the stock’s typical movement.
(update: this stock didn’t end up triggering a trade in late March. It fell before signaling a buy. This why all the rules are followed for a strategy. Don’t jump the gun and assume what will happen. Wait for the buy signal; sometimes it comes, sometimes it doesn’t).
Sometimes there may be a really nice trending stock that makes 20% runs to the upside, but to make that worthwhile, I need an entry that can capitalize on achieving that (potential) 20% and a stop loss that is less than about 6%. If the stock is whipsawing or choppy, and a reasonable stop loss is 10%, I’m not going to take that trade. 2:1 reward/risk, not good enough. If a reasonable stop loss is 3% or 5%, I’m taking the trade (assuming all the criteria for the strategy align).
When you make 4 or 5 times (or more) as much on winners compared to what is lost on losers, it becomes a lot easier to make money.
A stock like this could end up being a loser. That’s ok. About 50% of trades end up losers. But when you make much more on your winners, it’s still possible to do very well. Do the math over 10, 20, 30, or 50 trades.
Other Reasons Not to Buy a Stock
I don’t have a strategy for trading the current conditions in a stock. All methods of trading are outlined in a trading plan.
Overall stock market conditions are poor. Meaning even though an individual stock may look good, if the major market indices are weak that stock is facing an uphill battle. An exception is the indices are weak but the stock’s sector is still doing well and trades are working well in that sector. In that case, I will still take trades in that strong area of the market.
I want the stocks I trade to be stronger than the S&P 500. The S&P 500 is like “average” and I want better than average. If a stock hasn’t outperformed the S&P 500 recently or over the last year or two, I’ll pass.
Final Word on Reasons NOT to Buy a Stock When Swing Trading
If a stock isn’t in an uptrend, I’m not even looking at it.
If it has a bigger drop than normal, I’m leaving that stock alone for a while.
If the stock is choppy or has small runs to the upside before a pullback, earnings, or extended sideways period, I’ll pass.
If the price doesn’t run much, or the stop loss is too big, then I’m not taking the trade. I want the price to move enough, and provide an entry and stop loss location where I can reasonably expect to make at least 3:1 (preferably more) based on how the stock typically moves.
What does this boil down to? The stock needs to be in an uptrend, it needs to provide a good entry, a good stop loss location, it needs to run enough to adequately compensate me for the risk, and if all that happens I have a potential trade.
By Cory Mitchell, CMT
Learn how to find stocks that are ready to explode higher, typically jumping 15% to 30% or more, often in a matter of days. Know when to trade and when to stay out. It’s all covered in my Complete Method Stock Swing Trading Course. Still only $249 instead of $299.