When to Sell Stocks - a technical perspective

Wednesday, Feb 01 2012 by
7
When to Sell Stocks  a technical perspective

Knowing when to sell stocks is one of the most difficult aspects of investing. While there is no shortage of advice on buying strategies (whether value, growth or momentum), there's a lot less written by those in the know about how investors can apply some logic to their selling decisions. Even the great and prolific Benjamin Graham seems to have been fairly quiet on the subject, other than a brief reference to selling after a price increase of 50% or after two calendar years, whichever comes first. As a result,  many investors simply don’t have a plan in place to preserve capital and/or lock in profits. Instead, they are often swayed by fear of loss or regret, rather than by rational decisions designed to optimise their returns.  

Fighting Loss Aversion 

Studies show that, when making money on a trade, people often take profits early to lock in the gain but, when losing money on a trade, most people choose to take the "risky" option by running losses and holding the stock. Unfortunately, good investors usually do the exact opposite - they cut their losses and run their profits! The explanation for our generally irrational behaviour relates to "loss aversion", i.e. the fact that people actually value gains and losses differently. Behavioural studies have shown that losses have more emotional impact than gains and are weighted more heavily in our decision-making (some studies suggest that losses are twice as powerful, psychologically, vs. gains).  

To counteract this tendency, one option is to adopt a mechanical selling strategy based on strict rules (i.e.  a system of stop losses). One interesting mechanical approach is set out by American fund manager William O'Neill of Investors' Business Daily (IBD) as part of the CAN-SLIM method advocated in his best-selling book, "How to Make Money in Stocks". As O'Neill is a growth/momentum-focused investor, his system makes most sense in that context but there are some general principles that are certainly of wider interest. 

Cut your losers 

First of all, O'Neill notes that losses are inevitable for any investor and must be faced up to - "the first rule for the highly successful individual investor is . . . always cut short and limit every single loss". However, he notes that, to do this, takes never-ending discipline and courage. He cites Bernard Baruch, a famous Wall Street operator on Wall Street who said:

If a speculator is correct half of the time, he is hitting a good average. Even being right 3 or 4 times out of 10 should yield a person a fortune if he has the sense to cut his losses quickly  on the ventures where he has been wrong". 

O'Neill also observes that few stock selling rules involves changes in the fundamental of a stock. This is because many big investors get out of a stock before trouble appears and if the institutional money is selling up in volume, individual investors don't stand much of a chance. So while it's very important to buy with heavy emphasis on fundamentals, he argues that this is not the right thing to focus on when selling:

Many stocks peak when earnings are up 100% and analysts are projecting continued growth and higher price targets. Therefore, you must frequently sell based on unusual market action (price and volume movement).

Overall, O'Neill recommends using a 3:1 profit and loss strategy, i.e. locking in profits at 20-25%, while keeping losses at 7-8%. The idea is that, with a 3:1 strategy, you can be right only 33% of the time and just about break even, or hopefully you can be wrong more than half the time and still make a profit, A consequence of this kind of system is that one will invariably sell some stocks too early but, of course, if you don’t sell early, you’ll just be late. Quoting Baruch again: "I made my money by selling too soon". The object of investing is to take significant gains and not get over-excited and greedy as a stock’s advance gets stronger, as that leaves you exposed to a potential crash in the share price (in a very choppy market, O'Neill suggest even considering 2 or 2.5 to 1 win-loss ratio).

Setting your Stop Losses

Whenever a stock is bought, O'Neill proposes that a tight stop loss of 7-8% is set below the purchase price and that stock should be sold without hesitation if it drops down to or below this limit, no matter what the reason for the decline. If you follow this rule religiously, then obviously the risk in any stock you buy is a maximum of 8%. To investors who stubbornly ask “how about unusual situations  where some bad news hits suddenly and causes a price decline?” or “are there exceptions, like when a company has a good new product?", O'Neill's answer is - there are no exceptions and nothing changes the situation as you must always protect your capital.

He does however say that stocks may be sold earlier if "you can sense that the market or your stock isn't acting right or that you are starting off amiss" (e.g. if there are signs that the overall market is going into a decline, or if there is evidence that steady selling by institutions is holding back the price of a stock). The aim of this rule is to keep the average of all losses even lower than the stop-loss, ideally down to about 5-6%.

Taking trading profits

On the upside, he argues that most stocks should be sold if they do not show a profit of more than 20% within 13 weeks, or as soon as they have risen by 20%. His rationale is that most growth stocks tend to move 20-25% before consolidating at higher levels. Stocks that do not rise by this amount within three months are probably dud selections that should be sold so that the cash can be profitably reinvested.

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Holding the Big Winners

Locking in profits at 20-25% is a sound profit taking strategy for most stocks, but O'Neill recognises that there will be times when a stock exhibits the characteristics of a big winner (100% potential gain or more). If a stock rises 20% in less than 8 weeks, it should be held for a further 8 weeks and then analysed again to see whether it should be held for a long-term gain. The aim here is to hold on to stocks that have particularly strong momentum, in order to offset your small losses and provide a big gain for your portfolio.  For these longer-term holds, O'Neil specifies more than 30 different sell signals that may signal the end of the run. "The object is to get out while a stock is up, before it has a chance to break". Some of the more interesting signals are: 

A Climax Run

This is when a stock advance gets so active that it has a rapid price runup for two or three weeks. This is called a climax (blow-off). Viewed on a chart, the stock appears to be going vertical and, although this sounds great, it's time to sell. According to IBD research of the biggest winners over the past 50 years, practically all stocks that go into a climax run do not reach their peaks again, at least not within 10 to 20 years.

An exhaustion gap 

If a stock that has been advancing rapidly is extended from its base and opens on a gap up in price, the advance is probably near its peak. The exhaustion gap is a rush of last minute buying out of greed and it signals that there are few buyers left to propel the stock higher. In his example, a two point gap in a stock’s price would occur if it closed at its high of $50 for the day and the next morning opened at $52 and held above $52 during the day.  

New Highs On Low Volume

If a stock has had a nice run, but makes new highs on decreasing volume, it usually means institutions are getting tired of accumulating. This can be a turning point where supply is beginning to creep up on demand.

Extension Above Major Support

Some stocks may be sold if the stock climbs 70% to 100% above their 200-day moving average price line.

Excessive Stock Splits

O'Neill suggest selling if a stock runs up on a stock split for one or two weeks (usually + 25% or + 30% and, in a few rare instances, +50%). Stocks tend to top around excessive stock splits - not only does it increase supply, but it usually occurs after most investors have become aware of it.

Buying/Media Frenzy

Consider selling if a stock runs up and then good news or major publicity is released. When it’s exciting and obvious to everyone that a stock is going higher, sell because it is too late! As Jack Dreyfus said:

‘Sell when there is an overabundance of optimism. When everyone is bubbling optimism and running around trying toget everyone else to buy, they are fully invested. At this point, all they can do is talk. They can’t push the market up anymore. It takes buying power to do that. Buy when you’re scared to death and others are unsure. Wait until you’re hap py and tickled to death to sell'

As mentioned, the approach to selling outlined above is based on an underlying momentum philosophy of following stock trends until sentiment becomes too optimistic, which won't appeal to everyone (e.g. value investors). However, it does provide an interesting and useful framework for thinking about some selling decisions. 

From the Source

William O'Neil details this approach to selling to chapter 10 in his excellent book, "How to Make Money in Stocks: A Winning System in Good Times and Bad” (3rd edition - a more recent edition is available on Amazon). 

Further Reading


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