There is no universally accepted and defined method of swing trading. It is more of a practical trading style that can be applied across the board to markets as diverse as equity indices, currencies and individual large cap stocks. Being equally applicable to different time frames makes it just as relevant for day traders as it is for longer-term position traders.

In broad terms, swing traders aim to profit from the upswings and downswings in the market. The generally accepted view is that the risk-reward trade-off is at its most favorable when the mini and major trends are both moving in the same direction, namely when buying dips in a well-defined uptrend or when selling rallies in a well-defined downtrend.

Markets spend a lot of time churning around, especially in the smaller time frames. Within these sorts of choppy sideways conditions within established ranges is perhaps the best place to look to exploit the swings. Take the scenario of a move up being halted by profit-taking. The swing trader who believes that the bigger trend is up will want to buy on this dip when both the major and the mini trends are moving in the same direction.

The problem from a psychological perspective is that it can be difficult to buy into weakness (and sell into strength) because the markets always look bid at the top and offered at the bottom. That is why a swing trader needs a systematic plan to identify his or her optimum entry point and stop loss level, together with the discipline to stick to it. There are various practical ways to do this, although the choice of chart type is very much a case of personal preference. Many swing traders elect to use a normal bar or candlestick chart in conjunction with a set of indicator overlays to identify the swing points.

Momentum indicators such as the Moving Average Convergence Divergence (MACD) and the Relative Strength Index (RSI) are good in a sideways market. For example, when using an RSI indicator, it is more prudent to buy or sell against the immediate trend when the market is overextended, namely when the RSI enters overbought territory above 70 or an oversold area below 30. This signals a likely correction before another strong price move takes place. If a daily RSI is moving toward oversold, switching to an hourly RSI on an intraday chart could help to finesse the actual timing of the trade.

Clearly it is also safer to sell into a rising market if there is a strong layer of prior resistance and vice versa. This is especially applicable when shorter-term price moves encounter multiple layers of support or resistance evident in the daily / weekly chart.

Position traders can use swing trading to capture moves of anything from a few days to a few weeks. The aim is to get an entry into a medium-term trend for example, trying to catch the next upswing in an established uptrend following a retracement. The idea behind this is that it is better to enter the market at a point when the ongoing trend is about to resume.

Swing trading is also popular with day traders because it encourages discipline with both entry and exit strategies. For example, on a chart with an upward channel, there is every probability that an undisciplined trader would jump in at the top of the rally. A swing trader, however, would confirm the direction of the trend and then wait for the correction before trading. Typically, they may look for 3 lower bars (lower high, lower low), with the entry being the break of the high of this correction and the stop being set at the low.

The classic three-day swing chart was invented by the legendary trader WD Gann. His trading methods, coupled with a highly disciplined approach, generated big profits for him back in the 1930s. In fact, despite his famous forecasting ability, Gann is reputed to have made most of his money through what he called his mechanical trading method, namely trading with swing charts.

The idea behind swing trading is to identify the major market trend and also the mini corrections to it. In an uptrend, the principle is to buy on the dips as soon as the correction is over and in a downtrend to sell the rallies as soon as the correction has finished. This ensures that the major and minor trends are both moving in the same direction as the trade.

Such a strategy mirrors Gann’s view that, to make profits, traders have to follow the trend and change when the trend changes. The same idea is often expressed today in the expression, “The trend is your friend”. Swing charts were Gann’s method of actual implementation.

In going from a bull market to a bear market, Gann said that, after a prolonged advance, when the security reaches a final high, there is usually a short but severe decline lasting one, two or possibly three weeks or maybe even months. The market may then remain in a narrow trading range before experiencing a secondary bull rally.

Gann’s swing trading method identifies the trigger point for the short sell as coming after this rally when the stock breaks the swing low, namely when the stock breaks the bottom of the last reaction. At this point, both the minor and major trends are falling.

Moving from a bear market to a bull market follows the same principle, albeit in reverse. After the bear market ends, Gann said there is usually a rally that can last up to a couple of months and then a reaction back down again, making a higher bottom. The buy point follows when the minor and major trends are both rising.

The three-day swing chart reflects Gann’s view that the first correction should last for at least three consecutive days. In an uptrend, this means each day of the correction should have a lower high and lower low than the previous day. In a downtrend it is the opposite -- a day with a higher high and higher low than the previous day.

One problem with waiting for three consecutive days like this is that it can limit the number of trading opportunities. Because of this, some traders have developed their own system to identify mini corrections within the main trend.

One example is from the respected swing trader, Marc Rivalland. Rather than looking for three consecutive corrective days, he looks for three that are closely bunched, or within eight trading days for an index.

Rivalland publishes his analyses of the FTSE, Dow and the NASDAQ on his website (www.marcrivalland.com) although this information should not be viewed as a stand-alone trading tool.

One of the attractions of swing trading is that it naturally highlights two potential stops. With a long position, this would either be under the low of the signal day or under the closing price of the previous day. Gann’s original three-day technique involved far wider stops than most would feel comfortable with today. For example, in an uptrend he would continue to move his swing chart up until there were three consecutive down days.

Recommended reading: Marc Rivalland on Swing Trading and The Master Swing Trader by Alan Farley, both available from Amazon.

The full version of this article was originally published in Shares magazine.