Why I think targeting undervalued stocks for swing trading is actually quite difficult
“Is it a good idea to find undervalued stocks and make a profit through swing trading?” I am often asked this. To be honest, my experience is that using undervalued stocks themselves as targets for swing trading is much more difficult than people think. I feel that because they seem like a good match at first glance, it is a combination where the pitfalls are hard to notice. Today, I will write about the reasons for this.
The time horizon until the undervaluation is resolved is fundamentally mismatched
An undervalued stock refers to a state where the stock price is evaluated relatively low compared to the intrinsic value of the company. It is not uncommon for it to take anywhere from several months to several years for this valuation gap to be recognized by the market and for the stock price to approach its intrinsic level, a process known as “revaluation buying.”
On the other hand, swing trading is a method that seeks results on a time horizon of several days to several weeks. Even if you enter a trade based on the undervaluation itself, the timing at which that basis is reflected in the stock price moves on a much longer time horizon that is beyond our control. I feel that this mismatch in time horizons is the biggest difficulty in swing trading undervalued stocks.
Trading volume is low, and price movements are often sluggish
There are many cases where stocks that are left undervalued remain so because they have low market attention. Because attention is low, trading volume is also low, and the price movement of the stock itself often becomes sluggish.
Swing trading is a method that can only aim for profits when there is a certain degree of price movement. Even if you continue to hold a stock with low volume and poor price movement, you often end up with your capital tied up for a long period without it becoming either an unrealized loss or an unrealized gain.
The presence or absence of a “catalyst” determines success or failure
Whether an undervalued stock functions as a target for swing trading depends heavily on whether there is a catalyst—a trigger for the stock price to start moving. These are specific triggers that encourage a revaluation of the stock, such as the announcement of good financial results, tailwinds for the entire industry, the movements of major shareholders, or the announcement of a share buyback.
Entering a trade based solely on the reason that it is “undervalued” when no catalyst is in sight means you are just waiting for a trigger that you don’t know when will come. Conversely, if a clear catalyst occurs and trading volume begins to surge, there is room for even an undervalued stock to function as a swing trade.
Compared to thematic stocks, they lack momentum
What makes it relatively easy to achieve results in swing trading are stocks that are riding a clear theme or trend. Because many market participants are looking in the same direction, the stock price is likely to gain momentum, and price movements in the short term become larger.
Undervalued stocks are fundamentally at the opposite end of this state where “many people are looking in the same direction.” In fact, they remain undervalued precisely because many people have not yet noticed them or are not interested in them, so in terms of momentum, you are starting from a disadvantageous position compared to thematic stocks.
The risk of getting caught in a value trap on a swing trading time horizon
Stocks that look undervalued but are actually suffering from deteriorating performance or structural problems, and thus never rise in price, are called “value traps.” If you enter a trade on the short time horizon of swing trading and get caught in this value trap, there is a risk that you will be unable to move while holding an unrealized loss, far exceeding your intended holding period.
Entering a trade with the premise of several days to several weeks, only to find yourself holding a long-term “salted” (stagnant) position before you know it, is a common failure pattern in swing trading undervalued stocks.
Setting a stop-loss line also requires a different sense than normal swing trading
Undervalued stocks sometimes have the characteristic that after a long period of sluggish price movement, they move all at once when they do move. Because of this characteristic, if you set a stop-loss line with the same feeling as a normal swing trading stock, you may be triggered repeatedly by minor fluctuations during periods of sluggish price movement.
On the other hand, if you make the stop-loss line too loose, the risk of losses expanding beyond expectations increases if the scenario you envisioned collapses. You need to adjust how you set your stop-loss line while understanding the price movement habits unique to undervalued stocks, which are “long periods of no movement, and sudden movement when they do move.”
Do not overlook the cost of capital being tied up
While holding a position in an undervalued stock, that capital cannot be invested in other stocks with price movement. In swing trading, having capital tied up for a long period without movement is the same as continuously incurring invisible opportunity costs.
I try to view keeping funds in an undervalued stock without any guarantee of a catalyst arriving as a state of effectively paying a cost, even if there is no unrealized loss.
If you still want to make it work, narrow down your criteria
I am not completely denying the idea of targeting undervalued stocks for swing trading. However, to make it work, I believe you should participate only after conditions are met: not just because it is ‘undervalued,’ but because a clear catalyst has occurred, trading volume has clearly increased compared to usual, and the stock price has already begun to move.
In other words, you need a shift in thinking: do not use the undervaluation itself as the basis for entry, but rather use the ‘moment’ when an undervalued stock begins to move as the basis. Buy not because it is undervalued, but because an undervalued stock has started to move. I believe that not getting this order wrong is the most important condition for making undervalued stock swing trading viable. I feel that suppressing the urge to rush in early and maintaining a stance of waiting until a trigger can be confirmed is, in the end, the shortest path.
※ This article is intended for general information and sharing market perspectives, and does not recommend the buying or selling of any specific stocks. Please make investment decisions at your own responsibility.