Perhaps 90 percent of all market discussions and analysis you can read and find on the Web relate to why and when to buy a stock. Too little attention is given to what to do when it is time to say goodbye to a position. Personally, I can say that exiting a trade is now intuitive to me since the same research that leads me in, also leads me out. But a more concise understanding of when to leave a trade deserves discussion. This important observation was reminded to me from a very respected friend and fellow trader, Brian Shannon. Much of what you are about to discover in this important chapter are his thoughts. Choosing the exit is somewhat of a personal decision, and brings to mind a cliché I’ve heard many times, “The winners take care of themselves.” While I believe this is true, in order to maximize consistency and profitability, you must have a predetermined action plan.
As with any decision in the market, it is easy to let emotions dictate when to sell. If a trader allows feelings to dictate when to say goodbye to a position he or she will find the emotional battle from within paralyzing. When faced with a decision to close out a trade, some of the questions that will creep into our minds include, “Do I sell now and take a small loss, or do I buy more to average my price lower?” and “Should I sell for a small profit, or should I hold out for bigger gains?” Clearly these emotions are going to get in the way of making objective decisions, so we must have a disciplined and consistent plan of action that cuts losses at an early stage and allows our profits to run—the most basic trading goal. This plan of action you create should be based on the single most important factor, price action. In reality, knowing when to exit a position can be an agonizing experience to the undisciplined trader, especially when trading larger share size. Having exit strategies thought out in advance removes the chances of making sloppy emotional decisions.
Always remember, the market does not care what any of us think. Although the charts are a reflection of the psychology of all participants, our personal opinion simply does not count. In other words, “trade what you observe, not what you believe.”
Knowing when to cover a trade is best accomplished by letting the stock tell us when to get out. Before we get to specific strategies, it is important to consider the futile nature of trying to find the single best way of exiting a position. We need to recognize that there is no single best way to do anything in the market because we all have different objectives in terms of time in a trade, levels of risk tolerance, and of capital in our accounts.
With that in mind, we will now examine seven good reasons and strategies to exit a position. By having a solid understanding of these seven incidents of market action, we will be in a better position to sell based on an objective interpretation of the message the market relays to us in the form of a price chart. For simplicity we will refer to the long side of the market in all of the examples; however, it is important to recognize that these events are also valid on the short side by simply reversing the rules.
There are seven events that should motivate you to sell. These events can be best described as:
1. Initial protective stop
2. Gaps against the prevailing trend
3. Price targets
4. Hard-trailing stops
5. Electronic trailing stops
6. Moving average crossovers
7. Time stops
Initial protective stops (IPS) give us our first decision to sell because they are based on the interest of preservation of capital. Before we can even think about taking profits, we have to first consider risk—or how much can I lose? Long before we are in a profitable position, our stock has to pass an initial test of strength, which is to hold above our initial protective stop, or our threshold for pain. Said another way—the point in which we are wrong about the position. The nature of short-term trading and investing is to be in a position only while the stock is showing positive momentum. Positive momentum means that the stock is moving in the direction we anticipated (we can have positive momentum in a stock that is dropping if we are shorting the stock). Once a stock shows signs of reversing its momentum, traders and investors should be out of that position and in cash, or better yet, in another stock where their money is working for them.
The final judge as to the success or failure of a trade is price, and it is therefore the most important consideration when exiting a position. Price action is the building block upon which support and resistance are formed, becoming the bedrock of trends. The goal of a trader is to capture as much of a trend as the market allows for, and this is why price is our most important source of information. By having a protective stop, we will not succumb to holding a position because we “think it is a good idea.” The stop helps to remove emotions and opinions from the decision-making process, and this contributes to objectivity.
When initially entering the trade, the first technical consideration is price levels of support and resistance. For the same reasons we enter the position near support, we also recognize anything below it is likely to be substantial risk. Therefore, in order to protect against catastrophic loss, stops should be placed just below the most recent level of support. For shorts stops should be placed just above a recent level of resistance. In both cases (long or short), this is best determined on an hourly chart. Reviewing the chart in Figure 15-1, there are two circled areas that represented a breakout past short-term resistance that would support a good decision to buy. The arrows point out the low prior to the breakouts. If the breakout was to fail and the stock made a lower low, there would be no reason to be long a stock making lower lows. This would represent negative price momentum, a dangerous event that can lead to large losses. Another consideration is the location of the two short-term MAs. Both of the MAs are located just below the low that is pointed out, and as we know, moving averages will often act as support levels. Whenever we have more than one technical reason for being involved in a trade, it adds significance. In this case we had what appeared to be the beginnings of a new uptrend with the prior low and the rising 8- and 17-period MAs in the same location. Just below the prior higher low is often the ideal point to place our initial stop because breaking below that level would nullify the trend. See Figure 15-1.
FIGURE 15 - 1 The protective stop is the second trade you make following the entry. Once the trade is on, the protective stop must be set and entered into an electronic environment that will trade you out if prices meet the stop. Trying to commit the stop to memory or paper is the earliest sign of poor discipline. If you’re not committed to placing the stop electronically, you’re not committed to being disciplined.
Gaps against the prevailing trend occur when a stock in an uptrend suddenly gaps lower while you have a long position in the stock (or a stock you are shorting gaps higher). Keep in mind, gaps against the trend are not common, but when we do find ourselves in this unfortunate situation, it is best to sell the entire position. To define the significance of the gap, we do not consider 1 to 2 percent as qualification to be stopped out. Gaps of 5 percent or more are another matter. A gap of this magnitude will not typically occur unless there is a serious fundamental development. It is the market’s first message to you that something has occurred that may not yet be explained in the media. Price is most important, and price just told you to get out. As a general rule of thumb for gaps, liquidate the position if the protective stop or hard stop (sell event number 4) has been violated. If the stock gaps down 5 percent but does not violate a hard stop, we need to monitor the stock closely for further signs of weakness. If it looks like liquidity may be an issue for exiting a larger position, it is a good idea to consider selling half of the position. This way if the weakness continues you will not feel trapped in the stock and reluctant to sell as it declines, waiting for a bounce that may never arrive.
We can see in Figure 15-2, the stock gapped lower from a close near 17.00 down to just above 15.00 and did not bounce. Although it would have been a tough decision to liquidate the position on such a gap, by looking at the subsequent action, it is clearly better to have sold at the first sign of trouble than it would have been to continue to hold and hope. As a rule, it is best to get the pain over all at once by selling the entire position rather than prolonging the agony of a loser, just as slowly peeling a band aid from a wound only extends the discomfort.
FIGURE 15 - 2 The gap suddenly looks acceptable.
Price targets. It is a good idea to have a reasonable expectation as to where you believe the stock has the potential to rally to. This is the basis of a theoretical risk/reward ratio. Exiting under these conditions means mission accomplished. If our stock is in a solid uptrend that may be approaching a prior broken level of support, there is the potential for new resistance (support once broken tends to act as resistance). Assuming you started with a good theoretical risk/reward ratio in your original purchase, taking some of the profits makes sense at the target area. Also realize that total liquidation of the position is not warranted, since a stock that continues to have strong upward momentum is likely to follow through. By selling some of the position into potential resistance, we accomplish two things. First, it shows we are not emotionally attached to the stock, and we can let go. Second, it allows us to participate in follow-through with much lower risk if resistance is broken (breakout). This practice gives us a little cushion in case something unexpected happens (gap down) to make the stock drop suddenly. For the rest of the position, hold on tight and allow yourself to have a big winner. It is difficult for most traders to hold a winning position and let profits run, especially when the expected price target has been met. But as George Soros says, “It takes courage to be a pig.” Most participants do the opposite of what they should. They tend to take profits too quickly while holding loses too long. This is a recipe for failure.
Hard-trailing stops require the most skill, but by the time we get to this point, the stock is doing the work. Our job now is to monitor and adjust our risk levels as the stock moves higher. A hard-trailing stop is based on the very definition of the trends we are trying to take money from. As we know, the definition of an uptrend is “a series of higher highs and higher lows.” This implies that breaking the series of higher lows is a violation of the trend and that is a reason to sell. When looking at Figure 15-3, we can see how a trader would have used stop placement under the higher lows of the hourly time-frame to not only capture two nice trades to the upside, but to also sidestep disaster as the stock caved in. Assuming the first purchase was made at approximately $53 a share, the stock held the IPS and there was reason to continue to hold. As the stock gapped higher the next day, it traded above $54 and then made a higher high about midway through the day. At this point the stop should be raised to just under the lows of that support level (hard-trailing stop). Over the next couple of days, this process of raising the stop under the higher lows should have continued until the trade was stopped out just under $59 a share, locking in a gain of nearly $6. Exiting at this point allowed the trader to be in cash as the stock pulled back toward $56 over the next two days. The second purchase came two days later as the stock cleared resistance near $57.50. As you can see from Figure 15-3, the stock held above the IPS, and it should have been held with the stop being adjusted as the stock climbed higher. The trade was stopped out two days later with a gain of about $1.50. As you can see from the subsequent action, for those who held the stock on opinion and ignored price action experienced the gap lower and the subsequent sell-off, losing almost 20 percent over the next two trading sessions! This stop takes some work because you have to cancel and replace orders, but this is enjoyable work because it means you are locking in profits along the way. In this regard, the market is really working for you.
FIGURE 15 - 3 Hard stops work the same as IPS, the only difference is profitability. The truly unemotional trader acts accordingly either way. While profits are better than losses, enduring methods will reward both scenarios over time.
Electronic trailing stops are one of our favorite stops to use on short-term trades, especially intraday. This unique stop actually gives control of your order to the algorithm built into the system you trade with, assuming your firm offers such a tool. Many do not, and perhaps the best place to start is a free demo at www.realtick.com. They invented the electronic trailing stop, and none do it better. The ideal situation to use a trailing stop is when you buy a stock that finds rapid upside velocity, pushing the stock quickly away from your hard stop. In the situation where the stock may run $1 or more in just a few minutes, we are faced with deciding whether to sell the position and lock in the gains or to allow it to run further. We’ve all seen the stocks that can run $2 to $3 in the course of an hour or less, and we certainly don’t want to allow a nice winner to turn into a loser. The emotions that can be dredged up from this experience tempt the most disciplined traders to exit with the profit rather than allowing it to run further. These stops are going to be utilized most often within the first hour of trading, when emotions from the amateur buyers are often at an extreme. Fortunately, technology has given us the opportunity to mitigate the emotional decision process with the electronic trailing stop.
This stop works in the following way. Figure 15-4 demonstrates a stock that started to rally late in the afternoon the day before. The stock continued to progress higher, and because it was showing strong positive momentum and displayed a strong technical pattern, the trader locked in partial profits on half of the position and allowed the rest to be transitioned into an overnight hold. The stock closed that day at $18.58. The next morning the stock gapped higher at $19.11, and at this point the trader was tempted to sell the stock for a quick profit, but decided instead to allow the profits to run a little. When the stock was at a price of $19.28 he entered a trailing stop market order of $.15 ($19.13). As the stock exhibited further strength, the stop is automatically adjusted higher, but never lower. The trailing stop sets an actual stop $.15 (or whatever increment you choose) below every new high the stock makes. Keep in mind that this will turn into a market order upon the stop getting activated and this can cause slippage in illiquid or fast-moving markets. As you can see from Figure 15-4, over the next 23 minutes the stop was automatically adjusted 157 times until the trade was finally stopped out $1.79 higher than the original stop. That is a classic example of letting profits run as the result of good discipline and technology working together (no intervention needed on the trader’s part). Ideally a trader wants to use a trailing stop on all trades because it means a profitable position.
FIGURE 15 - 4 The trailing stop in action. This is a ride that everyone wants to take.
The most difficult decision for a trailing stop is how much room to allow the stock to have. We call this discretion. It’s like going fishing. If you hook a big fish and you tighten the line too much, the fish is sure to break off and you never taste your reward. In trading, if you set the stop too tight, you might get shaken out of the position before the stock runs its course. How much discretion you decide to give a trailing stop depends a lot on historical volatility and the price of the stock. The more volatile and higher priced stocks will need to be given extra room to wiggle while less volatile lower priced issues can usually be kept on a tight leash with just a $0.10 to $0.15 stop.
Moving average crossovers often signal the end of a prevailing trend and that is a good time to take profits on a position. For this example we will refer to Figure 15-5. Investors with a longer time horizon will find particular value using the MA crossover approach.
FIGURE 15 - 5 This indicates a timeless technical event that signifies the market is talking to you. The question is, are you listening? When an MA makes a cross, it indicates the trader has most likely given the stock plenty of price volatility since the MA will always lag the price. If it takes an MA to initiate a stop, the losses are likely to be higher.
Trending stocks tend to stay above the rising MAs, and Figure 15-5 indicates this stock remained in a healthy uptrend that would pause briefly at the 10- and 20-day moving averages where it would find fresh buyers to bring the stock higher. On September 22, the stock broke down to the rising 50-day moving average. This swift sell-off was reason for concern, but not yet a reason to sell, as stocks often find support at the rising 50-day MA. Three days later, the stock experienced another wave of selling and that brought the 10-day MA down through the 20-day MA. This action tells us that the short-term trend is now heading lower while the intermediate term is trending higher. This indecision tells us it is time to book profits. The stock is at $28.50, well off the high near $36, but still 62 percent higher than the purchase made four months before.
MAs are simple, but often misunderstood, technical indicators. They allow us to objectively identify trends on all timeframes with incredible accuracy. One of the common misconceptions about MAs is that MA crossovers are a reason to enter a position. We have found that moving average crossovers occur in a sideways consolidating market, and it is difficult to determine when these consolidation periods will end. Understanding that MA crossovers represent indecision allows us to recognize the value of the first crossover at the end of a trend as a reason to sell. Usually an MA crossover occurs after a trend has exhausted itself, and as trend followers there should be no clearer sign that it is time to exit gracefully with our profits before the market relieves us of them.
Time stops are a way of exiting a position that is stagnant. As traders, we encounter two forms of risk, and the previous six reasons to sell addressed the risk of price. This stop addresses our other form of market risk—time, which can be our biggest enemy in a trade. It can be the quiet killer of our equity. How many times have you neglected a stock in your account because it wasn’t doing anything? The time stop takes care of getting out of a position if it is not working as quickly as we would have expected. We will typically give the stock two to three hours before we consider selling the position out near our cost basis. For position trades, our patience is stretched easily and we give the stock no more than one to two days to get moving before we start to think our timing is off. When we get stopped out because of time, we will often re-enter the stock if it exhibits signs that it may be ready to move later on. You will find that many stocks that time you out are not re-entered since you see the stock objectively once again after exiting.
These seven reasons to sell are not meant to be the only reasons to exit a position, but hopefully they do give you something to think about when you look at closing out your positions. Keep in mind that there are many different situations that present themselves to us in the markets. The more strategies we have to take advantage of them, the more likely we are to attain our goals being in the elite group of Market Wise Traders, who consistently take money from the market.
Keep in mind, the basics of the methodology covered in the analysis of what to trade and when (top-down) were not any single strategy, but a combination of the methods that all must confirm each other. A bias was developed on the broad market, then followed with a series of steps that lead to a specific action. Chapter 16 reflects specific strategies that can be applied to the top-down approach. These strategies represent timeless approaches that have yielded tremendous profits with little draw down in capital.
