You got to know when to fold 'em
18-Dec-03. After a very successful year, I found myself with several weak and losing stocks in my portfolio. This came about for two main reasons:
• First, I lacked specific rules about when to sell stocks. I simply didn't know what to look for to recognize the difference between when a stock had peaked and when it was just making a short-term pull-back.
• Second, lacking specific rules, I relied too much on wishful thinking. Having been successful in the earlier months and seen several stocks pull-back but later recover and turn profitable, I had become too complacent about losses and didn't nip them in the bud.
Fortunately, my online brokerage recently sponsored a webcast by William O'Neil, founder of Investor's Business Daily, on how to use charts for selling. I've adapted O'Neil's selling strategy into four rules to guide my own selling.
Rule 1. Sell if price drops more than 8% below what I paid.
The reason for this rule is to protect capital.
William O'Neill pointed out in the webcast that being right once will make up for being wrong twice:
- Start with an investment of $5000
- Buy $5000. Lose 8%. Leaves $4600. Reinvest what's left.
- Buy $4600. Lose 8%. Leaves $4232. Reinvest what's left.
- Buy $4232. Gain 20%. End up with $5078, which is more than you started with.
I've always had this rule, but haven't applied it consistently. I need to. Hoping that a stock's price will go back up easily leads to holding on too long and losing even more.
Rule 2. Systematically (every week) sell the weakest performing stock in the portfolio.
The reason for this rule is to avoid investing money where it's not getting a good return.
Corollary. Use the proceeds from the sale to increase the position in a stronger stock.
The reason for the corollary is to always keep the money invested where it gets the greatest return.
Rule 3. Sell on indications of peaking or exhaustion (a "climax top").
- Price rises more than 25% in a week
- Gap up/down combined with wide daily range and narrowly separated open/close prices ("hanging man" or "long-legged Doji" candlestick pattern)
Rule 4. Sell on indications of trend reversal.
- Price falls below 50-day moving average 3 days in a row on heavy volume
- Negative directional indicator (-DI) greater than positive (+DI) and ADX line rising
See also: Candlestick patterns