Did you see the Dan Aykroyd-cum-Eddie Murphy flick "Trading Places"? If so, you may recall the scene in which a pair of commodity futures kings realize they have made a huge bet on orange juice that is souring badly. Randolph and Mortimer Duke rush down to the trading floor and urge their trader to "Sell, sell!"
Their decision was too late. Since they were the bad guys, they didn't get saved by a Hollywood ending.
As stock investors, we would be mortified to be in the Duke brothers' shoes. Stocks are wealth generators, yes. But they can turn into a financial quagmire as well. As long as a free market exists, the risk of taking a big loss - or letting a big profit deflate like a pricked balloon - is here to stay.
How can individual investors avoid the same fate as the Duke siblings? Simply follow three easy steps:
- Step 1: Learn a set of smart sell rules.
- Step 2: Follow them in every move you make in the market.
- Step 3: Never stop following those rules.
Many successful stock investors will tell you that to make good sell rules work, you first need a good set of buy rules. No question. Whether you follow the path of growth-stock trading or value-style investing, you need to buy right.
Doing so takes time, patience and hard work. But after you've made a good buy, the job is not even half done. You're perhaps only a third of the way there. Next comes watching the progress of the stock and finally selling shares when the stock's rally is through.
William O'Neil, founder of Investor's Business Daily, has helped individual investors for decades by presenting a complete system of buy and sell rules to find the greatest growth stocks in a bull market. This article will focus on some of the most important of those sell rules. Those who wish to learn all of O'Neil's major rules can read Chapters 9 and 10 in the latest edition of his book "How To Make Money In Stocks". Steps 4 and 5 in O'Neil's 2004 book "The Successful Investor" will also help investors hone their selling skills.
Sell Rule No. 1 - Cut Losses at No More Than 7% to 8%
The first and most important sell rule can be the most difficult to follow for many investors. After all, one of the most difficult things to do for many people is admit that they're wrong. But in the market as in life, everybody makes mistakes. The key to investing successfully in the market is to recognize when you've made a mistake and bail out to minimize the damage. That's where the 7% sell rule comes in.
IBD market research shows that 40% of all big winners return to or near their pivot points after breaking out. That same research shows that far fewer go on to big gains once down 7-8% from the pivot, however. Don't sweat the few that do bounce back. In the long run, you'll do better by consistently keeping your losses small.
A quick math lesson shows the impact of escalating losses. Say you sell a stock down 7% from your buy point. You need only make 7.5% on your next trade to get back to even. Let it drop to 25% from your buy point, and you need a 33% gain to return to square one. If it tumbles to a 50% loss, you need to double your money just to start from scratch. Given how rare gains of 100% or more can be, that's a valuable lesson in keeping losses small.
Bottom line: always sell a stock if it falls 7% or 8% below the price you paid for it. Don't worry about taking a small loss when you're wrong. When you're right on a big winner, you'll more than make up for it.
IBD cited Applied Films Corp. (AFCO) as a good example of this on July 22, 2004. As you can see in Figure 1, the stock logged solid gains for much of 2003. The maker of thin-film coatings for computers logged several down weeks in heavy volume as it formed a base in the fall of 2003 (Point 1). The stock broke out of that pattern in lukewarm trade (Point 2).
The breakout didn't take, and Applied Films formed a base on base. The action was smoother this time around, capped by a more powerful breakout in January 2004 (Point 3). But two weeks later, the stock dived below its pivot of 35.10 to as low as 32.15, an 8.4% drop (Point 4). At this point, people who bought at the breakout should have ditched their shares.
The stock mounted a feeble rebound attempt in lackluster volume for a few weeks (Point 5). A string of four straight down weeks knocked Applied Films back below its 50-day (Point 6).
Sell Rule No. 2 - Sell Your Shares into a Climax Run
There are plenty of ways great stocks form a peak and slide all the way back down to the base of their mighty climbs. One of the most common ways is when it seems everyone wants a piece of the company. The stock, after climbing 100% or more from its proper buy point, suddenly takes off. It rises 25-50% or more in a matter of a week or two. Viewed on a chart, the stock appears to be going vertical.
Sounds great, right? Sure. But in that moment of euphoria, that's the time to sell. The stock has entered what IBD calls a "climax run". It usually won't go up any more because no one else is willing to bid shares higher. All of a sudden, huge demand turns into a huge overhang of supply. According to IBD research of the biggest winners during bull markets over the past 50 years, practically all stocks that go into a climax run never reach their price peaks again. And if they do, it might take 10 to 20 years.
Sell Rule No. 3 - Make Your Exit When a Stock Makes New Highs on Low Volume
A winning stock's price run is no more than a tale of supply and demand. When the rally is fresh, a market leader typically roars to new highs on heavy volume. Now, what is "heavy volume"? Simple: when volume on a given day is heavier than its average daily volume over the past 50 sessions. Institutional investors - namely mutual funds, banks, insurers, hedge funds and other big players - are falling over themselves to grab shares and accumulate a meaningful position in the stock. They're willing to grab shares at high prices because they want to get in before their rivals do.
After a long run-up, stocks get tired. They may edge up to all-time highs, but volume dips below average. Now the rally is getting stale. Fewer investors - especially the institutional players such as mutual funds, banks and insurers - are willing to snap up shares. Supply is beginning to creep up on demand and eventually more people are willing to sell than buy. A series of new highs on low volume often signals this turning point.
Sell Rule No. 4 - Nail Down Most Gains at 20%
Not every stock will be like Home Depot was in the 1980s or Cisco Systems was in the 1990s. That's why growth investors should take profits when their stocks rise 20% from their proper buy points. If you take gains at 20% and cut losses at 7%, you can be wrong three out of four times and not get badly hurt in the market.
IBD founder O'Neil has one exception to the above rule: If a stock rallies 20% or more from its breakout point in just one, two or three weeks, don't sell right away. Hold it for at least a total of eight weeks. Why? Such a fast gain may mean the stock has the power to produce a 100% or 200% gain, or even more. So holding it for at least eight weeks gives the stock a chance to prove itself.
Sell Rule No. 5 - Get Out When a Stock's Breakout from a Late-Stage Base Fails
Everyone knows the four seasons: spring, summer, fall and winter. Great stocks behave in a similar cycle. They go through stages of rallies, forming bases (narrow price ranges over a period of time following a price run-up of at least 20%) in between each stage.
The more bases a stock forms, generally speaking, the bigger the climb it's made. This also increases the risk that the stock has peaked and is beginning a sharp drop. Usually, earnings and sales growth are looking handsome at the peak. But stock prices tend to reflect the future. No wonder stocks tend to peak well before the company's growth slows down fast.
In Figure 2, we look at Synaptics (SYNA). The firm, which makes touch-pad technology for Apple Computer, broke out of its first base in early May 2003 (Point 1), just as the stock hit around 10 a share, the level at which big-money investors typically start paying attention.
It ran up as high as 14.90, and then slid into what would become its second base. The stock lost 24% the week of August 1, 2003 alone (Point 2), shedding nearly 40% of its total value during the base. Its price action tightened up as it moved back up in the pattern's right side (marked by Point 3). The stock then broke out again in mid-December 2003.
Synaptics scored a 59% gain in its next run-up, and then dropped into its third base in late January 2004 (Point 4).
The stock began forming its fourth base the week ending December 3, 2004. But unlike the stock's previous patterns, this one was V-shaped and lopsided, traits that often lead to failure.
Synaptics broke out the week ending February 4, 2005, hitting a new high (Point 5). But the gains didn't last. Brokers downgraded the stock amid concern Apple was eyeing rivals to take Synaptics' place in making components for Apple iPods and notebook PCs. The news sent Synaptics crashing 43% the week after its breakout (Point 6). While predicting bad news can be tough, the misshapen, late-stage base would've told you to stay away.
It's All About Following the Rules
Stocks and the stock market in general all operate according to rules. The key to selling stocks properly lies in simply following them without exception. Always be armed with a sound set of sell rules whenever you buy a stock, and be ready to follow those rules when the time comes. They will not only help you avoid big losses, they will also guide you toward taking a profit to keep your portfolio growing.