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By Gregory Spear
The Spear Report
Like many natural phenomena, markets ebb and flow, rise and fall. Unlike the tides or other natural cycles., however, this rhythm is not predictable. At times, therefore, we may find ourselves caught in an unexpected downdraft, leaving us with positions that are underwater. It is in such times, and often in such times, that we give serious consideration to selling.
When the markets are behaving well, we may be tempted to pay little attention. After all, letting our investments appreciate while we sleep is every investor's dream. It may, however, also be the wrong thing to do. Here we want to explore the under-appreciated art of selling. Selling in the bad times... but also selling when things are good. Both are difficult to master, but both are also essential to maximizing profits and preserving capital.
A Brief History of Selling
If you never learned to sell, don't blame yourself. For decades, the brokerage establishment was committed to keeping that concept out of the lexicon of individual investing. Throughout the 80's and 90's, the "S" word rarely passed the lips of Wall Street brokers. Buying and holding became dogma on the Street and those who dared to contradict it were considered somewhat blasphemous. In terms of personal career choices, analysts risked much more for issuing a sell recommendation than for placing an outrageous price target on an Internet stock. We now know for a fact, thanks to the work of NY Attorney General Elliot Spitzer, that the suspicions many investors held about deliberately distorted analyst work in that period were well-founded. Sell side analysts, the brokerage's trading department and their own investment banking arm were all quite seamlessly joined, producing analysis that was specious, overly optimistic and quite profitable for the brokerage.
It took a major bear market and a $1.4 billion conflict of interest settlement against the major brokerages to bring the merits of selling (i.e. protecting capital) to the consciousness of the individual investor. In post-Spitzer Wall Street, there is now a quota system, where brokerage firms are required to have a certain percentage of sell ratings. But is this really any help to the individual investor? Hardly. According to Zack's, in every year between 2000 and 2004, stocks with the most sell ratings outperformed those with only buy or hold ratings.
So, if our brokerages have a lousy track record in guiding selling strategies, how do we know when to sell?
Many market participants never contemplate, let alone formulate, an exit strategy. For these investors, when a position goes against them, they are likely to engage in a variety of psychological defenses to manage their distress, ranging from hope to rationalization to outright denial, but none of these maneuvers meets the real need. Which is a bona fide risk management strategy; and this requires a methodology for selling.
While selling frequently generally correlates with poor returns, in some strategies frequent selling is essential, so it is important to know when it helps and when it hurts. And even in strategies involving rebalancing only once per year, selling is still important. Selling, when done properly, is our most powerful risk management tool. Any investment methodology worth its salt must force us to sell - both to lock in gains and to cut our losses. In trading, as in geopolitics, without an exit strategy, we inevitably find ourselves in a morass of problems.
Developing an Exit Strategy
There are three things that must be considered when developing an exit strategy. The first aspect is our timeframe. Long-term investment strategies can be based much more on fundamental factors (company earnings and guidance, as well as macro-economic trends) than on technical (chart-based) conditions because over the long-term, share prices fluctuate far more than shifts in fundamentals would rationally dictate. Long-term plays on the homebuilders, the HMOs or the energy patch are examples of investment ideas in highly profitable industries where one would do best to take a contrarian approach and buy sentiment-driven lows and only sell when it appears that the fundamentals of the industry have changed for the worse. These "value-on-the-move" companies and industries make great long-term investments and you will find many of them in the Buy List each week in The Spear Report. Some active traders use entrance and exit from the weekly Buy List as a short-term trading signal, but don't overlook the fact that the Buy List identifies exceptional candidates that have long-term potential, as well.
In shorter timeframes, like those used by swing traders with time horizons measured in weeks, selling strategies are typically developed based on chart parameters. We discuss elements of this approach below. Quantitative systems, whose proponents are known as "quants," disregard most technical indicators, and instead use various company fundamentals and key ratios, sometimes in combination with simple technical factors like price momentum or relative strength, to trigger trades mechanically in various time frames from daily to yearly or longer. The current Buy List formula is an example of a "quant" approach to screening our proprietary Consensus list, and the current formula, which has evolved since the Buy List was launched on 2/7/03, backtests to around 500% over that period! It is hard to beat a good quant approach, especially when combined with Consensus! Secondly, an exit strategy defines risk. All trading and investing involves the assumption of risk. There are two aspects of risk one needs to be aware of proportional dollar risk vs. total portfolio value and psychological tolerance. The dollar value of risk pertains to the difficult of recouping losses, particularly large losses. A 50% loss requires a 100% gain to just get back to even. Most large losses start out as small ones, so one must be particularly careful to nip this weed in the bud. Methodical traders use careful position sizing, an awareness of a stock's inherent volatility (called beta) and technical support factors to craft an appropriate risk reward scenario before a trade is initiated, so that the role of psychology, which becomes a much larger factor after the trade is made, can be minimized.
Even if one is not a technical trader, one also needs to know the limits of one's psychological risk tolerance in order to trade/invest appropriately. One's risk tolerance is defined as the degree of uncertainty that one can easily handle in the case of a negative change in the value of a position or a portfolio. One man's excitement is another man's nightmare. An investor's risk tolerance often varies with age, income requirements, earning power, trading experience, confidence level, net worth, trading style, trading timeframe, personality, etc. There is no one-size-fits-all formula, but if you are obsessing or having trouble sleeping because of your investments, you know you have exceeded your risk tolerance.
The third aspect of an exit strategy has to do with knowing when to get out. Assuming one has defined a trading timeframe and an acceptable level of financial and psychological risk, this is where we deal with things like targets, resistance, stop loss orders and trailing stops. Books have been written on the varieties of options available to traders and investors in this regard. Indeed, exit algorithms are a key factor in professional portfolio management and are often kept proprietary, along with entrance criteria. Once again, there is no definitive answer, much depends on the personal and portfolio variables cited above. That said, here are some things to consider as you formulate your own plan.
Targets for trades/investments can be set technically, based on chart parameters, or they can be based on a percentage or dollar amount of gain, or again, in the quantitative approach, they can be based on changing fundamentals and key ratios, including some price performance data.
The chart analysis process can be as simple as looking for the nearest previous swing high, or as complicated as calculating pivots or Fibonacci retracements and extension clusters.
Using dollar or percentage gain targets for a trade can be problematic, as they tend to be conditioned by one's psychology and may be either too grandiose or too pedestrian, and in any case, these types of selling systems completely ignore the investor's main job of assessing what the stock is going to do next. You should sell only because you believe that future price appreciation will not meet your expectations. Clearly, your own personal entry price can have no bearing on the stock's future, so a rational sell system must completely ignore the purchase price. That said, many investors use simple systems like "never let a profit turn into a loss" or they sell if their loss exceeds a certain amount like 6%-8%. The former approach certainly does limit losses. You're portfolio can't lose money if your individual trades don't lose money, so any system that rigidly avoids an unnecessary loss will preserve capital, even if it doesn't make any money. The latter approach, however, ignores the fact that many small compound losses can easily exceed a 100% loss on one trade held "for the duration." For example, if you limit the amount you invest in each trade to a value of about 5% of your portfolio's total value (which we recommend), then even a 100% loss on one investment held patiently for a year, would mean a loss of only 5% of your total capital. If you sell frequently, however, at say a 6% loss on each trade, and you take one such loss a week, then it takes only 8 such "protective" sells over 8 weeks to cut your portfolio value by 48%! This strategy has proven to be a deadly end to many short-term traders.
Setting targets that are based instead on fundamentals, key ratios, or technical factors can help overcome short-sightedness and impatience, and help the trader to stay focused on the trade's potential, without undue influence by psychology. Targets remind us of the full potential of a trade and encourage us to "let our winners run."
Selling When the Weather Changes
Either way, we must remember that targets are probabilities, not certainties. One piece of news - such as a company lowering earnings guidance - can completely alter the course of expected price developments for months or even years, depending on its import, and should change an investor's target price. Moreover, targets tend to work only in cooperative market environments. Tenaciously holding on to a predefined target can be tantamount to denial. Charts simply reflect the history of the consensus of value for a stock and that consensus can change on a dime due to new company information or general market conditions. Many beautiful rallies in fabulous companies have been stalled or aborted simply because the market as a whole entered a downswing. This is why market timing often becomes a key factor in our decision to sell. Unlike larger funds, as individual investors we have the luxury of nimbleness; i.e. being able to quickly enter and exit positions based on the market weather. In these days of the $9 trade, be sure you take advantage of that opportunity.
The gladiator pit of trading is the Chicago Mercantile Exchange, where for years, professional futures traders have used an open outcry system and hand signals to conduct business with each other at a furious pace. This highly leveraged market is now also electronic and the techniques of the legendary floor traders have been shared, analyzed and disseminated in books and seminars to the hordes of eager and amateur and semi-professional newcomers who seek extraordinary gains from buying power enhanced by 10:1 margin. Perhaps we can learn a thing or two from those who have survived and thrived in this challenging environment.
One thing futures traders have in common is a tendency to sell into strength and to sell into resistance. These traders usually have definite, mathematically determined price targets and when these targets are met they don't hesitate to take profits. Moreover, they tend to take profits along the way, often taking off a third of their initial position once a small profit has been attained, moving their stop loss to break even, and then selling more as the price moves up toward their resistance target. The beauty of this risk management technique is that risk is assumed for the shortest amount of time possible. This makes a great deal of sense in a very high-risk environment. Once the trade has advanced an amount equal to their initial risk, a portion of the profits are booked and when the stop is raised there is virtually no risk to the position. People tend to trade differently when under the stress of risk, so removing risk at the earliest possible moment provides a psychological benefit that helps these traders manage the balance of their position more rationally. While most equity investors are not involved in such a high risk, high pressure environment, the principle of taking partial profits along the way may be a useful one for you, if it helps to limit effect of psychology on your future decisions.
By the way, selling into strength not only means taking reasonable profits on a regular basis but also selling when price is accelerating to the upside in a rapid, unsustainable manner. Mini-bubbles happen all the time in trading, often as a result of forced buying by short-sellers, and they are best used for profit taking.
Whether you are setting targets and/or selling into strength (higher prices going higher) or resistance (higher prices at which the stock has stalled), most successful swing and position traders use trailing stops as a means of locking in profits. These are orders to sell a position if price declines a certain amount below the recent high and they serve to preserve a portion of profits and limit losses in pullbacks. Once a profit is established, a stop is set to give the trade a reasonable amount of leeway but protect against a loss, or to preserve a certain return. Depending on technical or market factors, the stop may then be loosened or tightened as it progresses. If the stock has made a very rapid gain, for example, a short-term swing-trader might use a very close stop to lock in this gain, anticipating that a likely correction would be an opportunity to re-buy the trade at a lower price.
How far away from the recent high should the trailing stop be set? For position trading (trades the last months or years) this can be based on a violation of a previous swing low. For intermediate-term trades and swing trades (lasting days to week), trailing stops can be based on the violation of a significant moving average or a retracement back through a level that should have acted as strong support, such as the mid-point of a high volume wide range day.
It should be noted, again, however, that using stops without a correspondingly precise entry strategy is a pathway to continual losses. For example, subscribers to Investors Business Daily will be familiar with William O'Neil's 8% stop loss rule, but if this rule is applied out of the context of the rest of O'Neil's investing system, that is, without consideration for making an intelligent, low risk entry as O'Neil prescribes, then most trades will result in losses. Your 8% loss may be a wiser trader's perfect entry price. Be the wiser trader, not the one who buys at an arbitrary level and sells at an arbitrary 8% below that arbitrary entry.
Selling Strength?
Why Not Buy Dips?
The strategy of selling into strength/resistance is the opposite of the standard approach of adding to positions on weakness or pullbacks. Both approaches are valid. When should we favor one over the other? This is where market timing considerations and trending conditions come into play.
About two-thirds of the time, markets are in trendless trading ranges (moving up and down without new highs or new lows, in the same general price area) and most stocks behave in a similar manner. In other words, about 2/3 of the time, you stand a good chance of buying a stock that is still in a trading range. In such cases, applying the buy low and sell-into-strength strategy will work best. In fact, one should assume that all trades are trading range trades until proven otherwise. Accordingly, before entering a trade one should look for a nearby price target based on simple resistance theory, such as a place where significant selling happened before. These spots, such as previous swing highs, are the logical places for at least partial profit taking.
One third of the time, on average, stocks will actually be trending. Of course, they trend both up and down, so by that measure roughly 16-20% of the time a stock will be in a buyable uptrend where you will get paid to buy the dips. Finding these rarer stocks can be very rewarding and they are the engines of the long-term investing approach mentioned above. Stop loss strategies for such long-term investments usually are based on using a violation of the most recent major swing low as a sell trigger.
Editor's Note: Gregory Spear is editor of The Spear Report, 45 Wintonbury Ave., Bloomfield, CT 06002, 1 year, 50 issues, $297. Provides consensus stock picks from over 120 top-performing sources, researched and ranked weekly using a proprietary performance-weighting system. Includes full fundamentals, online sorting and screen capabilities, weekly stock profiles and market analysis. Weekly Buy List of 20 stocks to own now. For more information and Special Trial offer, visit www.SpearReport.com or call 1-800-491-7119.
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