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.
The exact percent doesn’t matter. It is relative to what has happened before. A 15% drop may be a warning if prior drops were around 5%. A 30% drop may be ok if that is normal for the stock and it quickly rebounds from those declines.
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 with an initial 20% drop, a pattern formed by a 40% drop is of no interest to me. The price would need to rally and then start forming smaller drops again before I get involved.
If a trend channel has been dropping approximately 10% and rallying 15%, a 25% 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 a pullback or a bit of sideways movement is bound to happen on some 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 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. I can get in after, but I am not holding trades when earnings comes out.
Looking at price patterns in the past, loosely based on patterns I may consider trading, the stock tends to only rise 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. That said, if I get a trade with a small stop loss, such as 2% or 3%, then even 10% upside is a great reward:risk.
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.
The High Momentum Trend Strategy (TATR) sometimes does ok in these types of stocks because it uses a trailing stop loss and thus will sometimes be able to hold through some pullbacks. In this case, I would apply the indicator to the chart and see how it has done so far in keeping me in for nice profits. If it has been producing nice profits, I may trade it. If the profits are tiny, I stay away.
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 be likely to hit the target quickly) 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 before slowing down again or having an earnings announcement (which I have to get out for).
On a slow-moving stock like that, I am likely going to have to set a profit target between 5% and 10%. Because the price doesn’t move much more than before leveling off for months. Maybe I could get 15% if I happen to get lucky and catch a bigger burst (but I prefer NOT relying on luck!).
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 and rallying.
I only take trades where I reasonably expect to make AT LEAST 3x my risk, based on how the stock actually moves. [Note: tailing stop loss strategies like TATR and Earnings Plays are different. I don’t know the R:R at the outset of the trade, but I am only trading these stocks that move a lot, so a good R:R is likely, and over many trades I can verify that I am actually getting a good R:R on these trades, which I am.]
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 is why all the rules are followed for a strategy. Don’t jump the gun and assume what will happen. Wait for the buy trigger; 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 is 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. Even taking profits at 3:1 is fantastic, and you are generally out of trades within a couple of weeks if you follow the guidelines in this article.
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
Here are some other reasons I don’t buy a stock.
- If I don’t have a strategy for trading the current conditions in a stock. If it looks unfamiliar, I stay out.
All methods of trading are outlined in a trading plan. If it doesn’t match a strategy I tested and written down, I don’t trade.
- 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 if 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. But nothing holds up against a falling market for long. Tread cautiously.
If the market is going down, can consider shorting weak stocks.
- I want the stocks I trade to be stronger than the S&P 500 (for long positions). The S&P 500 is an “average” and I want better than average. If a stock hasn’t outperformed the S&P 500 recently, 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. It needs to be building some strength for it to even show up on my stock scans (for long trades).
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 is in an extended sideways period (like years, because that is not an uptrend), 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.