Include Short-Term Trading Tools in Your
Trader's Toolbox
- Here's How to Use Them
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When I meet another
trader I often ask
what type of trading
he or she does.
I usually hear
something like: "I'm a Long-Term
Trader" or "I'm a Swing Trader."
The conversation then often turns to
current market conditions and
whether or not the current market is
"good" for trading. If market
conditions are "bad" the trader
either talks about holding off trading
until conditions improve, or the
importance of sticking with a system
and "riding out" the drawdowns. The well-rounded trader needs tools for trading in up markets, down markets, trending markets, and sideways markets. Successful trading requires a variety of strategies that work in different market environments and a technique for selecting the most appropriate strategy for the current market conditions. Traders with limited toolboxes may find themselves sitting on the sidelines, or worse yet experiencing drawdowns, for extended periods of time. Traders who trade only long or only short positions are limiting themselves to trading in certain market conditions. This may also be true for traders who focus exclusively on swing or intermediate-term trading techniques. Short-term trading techniques provide a way to generate profits when the market environment is not favorable to longer-term techniques. Once the trader has a toolbox to produce set-ups for different types of markets, the next step is to vary the trading style; longterm, swing, or shortterm based on market conditions. Intermediate or long-term trading works best when the market is in a clear trend. Swing trading works best when the market is oscillating in a wide base or trending. Short-term trading techniques may be used in narrow or wide bases and in trending markets. It is generally best to use the longestterm technique that the current market conditions allow.
There are at least two ways to trade this breakout. Short-term traders focus on capturing the initial thrust of the breakout. Swing traders place a stop just inside the base and give the pattern more time to develop. In the case of a successful retest of the breakout, swing traders usually come out ahead of short-term traders. As noted above, when market conditions are strong swing trading is generally preferred over short-term trading. Figure 2 shows a base breakout failure. Fidelity National Financial (FNF) broke out of a two-month base then immediately fell back into the base. In this case, swing traders were stopped out for a loss while shortterm traders had an opportunity for a quick profit. Short-term trading can yield better results than swing trading in an environment where breakouts are likely to fail.  I generally use short-term techniques when the market is trading in a narrow range, or after an extended run when the market is either overbought or oversold. Breakouts have a high failure rate during these conditions so I focus on taking quick profits after the initial moves rather than waiting to see if the breakout might be successful. Short-term trading is not day trading - it is adapting holding periods to the market environment to capture quick profits on the initial move. I don't want to let a quick profit get away in an environment where breakouts are unlikely to have sustained moves. Figure 3 shows the NASDAQ during Q4 of 2003 through Q1 of 2004. Short-term trading was more effective than swing or intermediate-term trading during the narrow range trading the first half of November and the first part of February. I also switched from swing trading to short-term trading in mid-January after the market had a nice run and was showing signs of being overbought.  When the market is overbought (mid-January, Figure 3) swing trading becomes more risky. An overbought market can, and often does, become more overbought but the situation is usually relieved through a retracement or a basing period. Either of these moves would make swing trading difficult, so switching to short-term trading techniques lessens the risk of giving back hard won profits. Knowing when to exit Short-term trading requires quick, decisive action. It's generally a bad idea to wait for a stop to take you out of a position. Knowing when to exit is the hardest part of this game. I have developed several guidelines that have proven helpful in this process. 1. Backtesting results from most of my scans show interesting results using a fixed two-day holding period. This is consistent with what we see by looking at the charts for stocks breaking out of pullbacks, bases, or flags. Thus, when the market implies that short-term trading techniques should be used, you need a very good reason to hold more than two days. Take the quick profit - no one goes broke taking profits. 2. The Bollinger Bands contain the vast majority of the price action. In a strong market, stocks can and do move outside the bands or “ride them up.” However, in a strong market it is preferable to use swing or intermediate-term techniques. Since short-term trading is generally done in uncertain market conditions, I take profits as a stock approaches one of the Bollinger Bands. 3. Watch what happens to breakouts whether you took the trade or not. If most breakouts are working, consider swing trading. If most are failing, note the typical time and the number of points to the peak of the breakout and use this information in your exit strategy. 4. Since short-term trading focuses on quickly taking small profits in an uncertain market you cannot afford big losses. Exit at any sign of weakness in the stock or the market. If the trade moves against you by an amount near the expected profit, consider closing the position. 5. When the market is in a narrow trading range, focus on long trades when the market is bouncing off support, focus on short trades when the market is retracing from resistance. Be very careful taking trades when the market is in the middle of the range. Trading is a statistical game Short-term traders need a clear understanding of how the market typically behaves in different situations, and an ability to understand how the market is likely to react at key levels. No one reads the market correctly all the time, but it is possible to get good enough at it to improve the odds. Until this becomes a skill, it's a good idea to work with someone who has experience in this area. Trading is a statistical game and you want the odds on your side. In the 100 trading days prior to 02/10/ 04, the NASDAQ was up 54 days, roughly a coin toss. However, it was up four or more days in a row only three times. In the 100 trading days prior to 09/10/03, it was up 55 times but up four or more days in a row only five times. I conducted this test back to the end of 1999 in 100-day increments and found that the probability of the NASDAQ being up four or more days in a row is 5% or less. This implies that if you are short-term trading you should have clear reasons for entering a new long position after the market has been up three days in a row. Some traders have been taught to enter short-term trades at the end of the day when it looks like the market is going to close in the extreme top or bottom of the range because they expect follow through in the next trading session. Fortunately, AIQ has provided us with an excellent set of tools to test most assumptions. Table 1 shows the number of times the index closed in the top or bottom 10% of the daily range then moved up or down the following day. The tests were run over the 100 days prior to the test date. For example, the test run for the 100 days prior to 02/04/2004 shows that of the 25 times the NASDAQ composite closed in the top 10% of it's daily range, on 10 occasions it was up the following day and on 24 occasions it closed down the following day (one time it was unchanged). During the 400 trading days tested, the NASDAQ closed down the next day after a top 10% closing about 57% of the time.  Are certain days of the week better for trading? Some short-term traders believe that certain days of the week are better for trading than others. I also tested this idea and did not find a significant advantage, as shown in Table 2.  Table 2 shows the percentage of time the NASDAQ composite is up on a given day of the week during the test period. Each test period is the 100 trading days prior to the test date. During the 400 days tested it seems that Monday and Friday have a smaller variance than the other days of the week, but there is nothing that would cause me to focus on day of the week rather than the other items mentioned above. How to deal with gaps Most discussions on short-term trading eventually come around to how to deal with gaps. Table 3 provides information on NASDAQ gaps. A gap up occurs when today's open is greater than yesterday's close. A gap down occurs when today's open is below yesterday's close.  The testing was done for the 100 trading days prior to the test date. % Up Days is the percentage of time the NASDAQ closed up during the test period. % Gap Up is the percentage of time the NASDAQ gapped up at the open. % Gap Up & Fill Today is the percentage of time during the test period that the NASDAQ gapped up then filled the gap at some time during the rest of that day's trading session. It's interesting to note that gaps are not only common but they happen most of the time. The useful insight for short-term traders from Table 3 is that gaps are filled two thirds of the time. This may be where the often-heard advice not to trade in the first half hour comes from. Since the market gaps most of the time and fills the gap two thirds of the time, the short-term trader may get a better entry by waiting for the market to fill the day's gap instead of taking the entry if it triggers on the opening gap. Short-term trading is typically harder than trading longer-term techniques but should be part of the trader's toolbox. It is important to master several different trading styles and let the current market conditions tell you which one to use. It's not only important to take trades in the direction of the market, but also to use the market environment to adjust the style of trading used. Steve Palmquist |