In Part 1 of this article we investigated how Swing charts can help increase our probability of success and reduce the level of risk we take each time we trade. In this article we will use Swing charts to actually trade a stock using very simple entry and exit rules. Normally you wouldn’t use Swing charts as a stand alone tool as they are generally used to aid in determining the strength and direction of a stock. However, I want to demonstrate to you how effective this tool can be when used correctly. It will also help you understand how to use this tool without your judgement being affected by other methods of analysis. If you can effectively trade the share market using one tool, then you can determine how much it will add to your overall trading success if you decide to include it in your trading plan.

Before we begin I want to discuss Swing chart trading and how this relates to Dow Theory of higher peaks and troughs to determine entry and exit rules. According to Dow, if a stock confirms a higher peak after forming a higher trough you buy, and if it confirms a lower trough after forming a lower peak you sell. Swing charts work exactly the same only you replace the word ‘peak’ with swing high and ‘trough’ with swing low. While on the surface it would appear that these theories are similar, in reality they are quite distinct and need to be treated as such. Unfortunately many traders become confused between the two when learning how to buy and sell shares, which usually results in problems due to incorrect analysis.   

Remember, Gann Swing charts simply provide a visual representation of the price movements on a Bar chart. As price moves higher or lower on a Bar chart, this is reflected in a Swing chart moving higher or lower. For example if a bar has an equal or higher low and a higher high then the Swing chart will move up in price; if on the other hand a bar has an equal or lower high and a lower low then the Swing chart will move down in price.

When constructing Swing charts, however, you also need to consider outside bars, which is where this theory differs from Dow Theory. An outside bar is where price has travelled both lower and higher than the previous bar. In Dow Theory, an outside bar is generally treated as part of the overall trend and not as a peak or trough. Swing charts, on the other hand, are designed to reflect all movements in price; therefore in the middle of an uptrend an outside bar will have the effect of creating a swing high and swing low. In Figure 1 below I have provided a graphical example to demonstrate this. Notice that the Bar chart has one peak and trough while the Swing chart has two peaks and two troughs for the same movements in price.



Figure 1

Now let’s get stuck into trading a stock using a weekly Swing chart. Below is a chart of CBA (Figure 2) which shows all entry and exit signals together with the date and price of each trade over 2.7 years. My trading plan is as follows:

Buy: When the stock rises $0.01 cent above the previous swing high after confirming a higher swing low.

Sell: When the stock falls $0.01 cent below the previous swing low after confirming a lower swing high.

Stop Loss: Not used

As you can see, my entry and exit rules are very simple. Given that I have chosen to use this tool in isolation to demonstrate how effective it can be I have not used a stop loss. Remember, however, that this is just an exercise and you should always use a stop loss when trading the share market.


Figure 2

As you can see we completed five trades over 2.7 years, with the average length for each trade around four months. Using Swing charts only, or ‘Swing trading’ as it is called, you can see that it is generally a short term trading style, just like Dow Theory. Our shortest trade was 13 days and our longest trade was 221 days; therefore, this type of trading, although short term, can lead to more medium term trades but the majority will be short term.

Figure 3 below shows that four out of the five trades were profitable. From this we could assume that swing trading on its own can provide a win/loss ratio of at least 80% for this stock. In other words, when trading CBA using Swing charts we can predict that we will be right eight out of every ten times we trade.

Now I don’t know about you but most, if not all, traders would kill for an average win/loss ratio like this. Remember, however, that trading is about making profits not just getting a good win/loss ratio. This is because you can have a 4:1 win/loss ratio and still lose on your portfolio. Let me explain. If the four winning trades gross a 60% profit and you lost all capital invested in the fifth trade, your overall profitability will be in negative territory.    


Figure 3

As shown in Figure 3 the best trade grossed 26% or 75.92% annualised, while the average profitable trade was 14.18% or 33.16% annualised. The only loss was 5.2% which lasted 13 days in total. What do you think the outcome would be if we had bought and held one trade on this stock over the term from the entry point of Trade 1 to the exit point of Trade 5? We would have in fact achieved a capital gain of $12.67 on our entry price of $11.41, which is a 111.04% profit or a gross annualised return of 40.82%. Obviously we would have achieved a much better return than we did trading the stock five times. Of course, this sort of strategy may not work all of the time.

So looking at these figures we can now say that this method of analysis is very profitable. How profitable you are, however, will be determined by your position size and whether or not you used a leveraged position.

For example, let’s say you decided to trade CBA in $1000 amounts using Swing trading. On trade 1 you would have made $92.02 gross profit not including dividends; however, after brokerage and capital gains you may not be left with too much. But if you had traded a $10,000 position you would have made $920.00 which is obviously much better. Working out whether or not you are profitable is something many traders fail to do. As you can see, trading successfully is not just about picking winning trades; positions sizing and money management is where the battle is won or lost.

We have now proven that Swing charts can be 80% correct in picking entry points and as a result we can assume they will assist in reducing the risk we take when entering a trade. What is even more interesting is the fact we were profitable even though in the trading plan I didn’t take into consideration any other factors such as the direction of the current trend.

Even though Swing charts appear to be a great tool in isolation I would never use just one tool to trade the market. This is because we need to be realistic as we can get anything to work in hindsight. In fact if you hadn’t noticed the example on CBA was done during a bull market and trading is always easier in a bull run.

The question then is would this buy and sell strategy work in a bear market or a sideways moving market? The simple answer is no if your intention is to trade long, because in a sideways or down market your win/loss ratio would most likely be very different. If on the other hand your intention was to short sell, then you would most likely be able to use this theory in reverse to help you increase your accuracy. This brings us to the realisation that to effectively use Swing charts in any market we need to be aware of the short, medium and long term trends and trade accordingly.

Now let’s investigate how you could increase the profitability of your trading using Swing charts. Of course, your trading plan and the time frame in which you want to trade will determine how you use Swing charts. If your style is to trade short term then you could use Swing charts in the same manner we have in the example above, with the addition of a stop loss.

If your intention is to trade the share market over the medium to longer term then you could use Swing charts in combination with trend lines or other trend following indicators. For example, you could use a Swing chart for your entry and exit rules to go long in a stock.  As the trade unfolds and you have a confirmed uptrend line on the stock, you would replace the Swing chart to use the trend line as your exit rule. This would have the effect of keeping you in a good trade for longer and increase your profitability.

Another way to use Swing charts is to combine charts of different time frames to ascertain the strength and direction of the market that suits your trading plan. For example, if you intend to trade over the medium term then your entry rule could be that both the weekly and monthly Swing charts need to be pointing in the direction that you intend to trade. However, be aware that applying this rule as an added filter will at times keep you out of trades that you might have otherwise entered, but it will increase your accuracy and profitability.

As a general rule of thumb when using Swing charts both the time frame of your trade and the next highest time frame should be pointing in the direction you intend to trade. For example, if you are a short term trader using daily charts for your entry position then both the daily and weekly Swing chart must be pointing in the direction you are trading. If your intention is to trade medium term then the weekly and monthly Swing charts need to be pointing in the direction you intend trading.

There are many other things I could share in regards to Swing charts and how you can use them to help you trade better. For now I would suggest that you pick several stocks from the Australian share market on which to apply the principles you have learnt in this article. By paper trading several stocks using this technique you will gain confidence in how to use Swing charts as well as reaffirm to yourself how effective they can be in helping you trade.

Many people rely on stock trading tips from stock broker reports rather than learning how to trade the share market themselves, which is what I have tried to encourage you to do here, and this is one of the reasons why 90% of traders fail. For further stock market information I suggest you listen to my podcast Stock Market Trading Tips.

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