When it comes to selling, you have 2 choices
The market extended its
recent consolidation today as is wiggled back and forth and finished slightly
positive. The S&P 500 has now closed between 1249 and 1269 for 15
days in a row. Today’s quiet action is no surprise ahead of the Fed meeting
tomorrow. The reaction to the Fed’s statement could easily provide the catalyst
to break us out of this trading range (in either direction). The trading bias
here remains long but that could change quickly should current support levels
give way (1249 S&P 500, 2230 Nasdaq).
Last week I discussed protective stops as the
first in a series of “when to sell†columns. Today we will look at part one of
profit taking.
Deciding when to sell and take profits is
normally the most difficult decision that traders face. It is also the decision
that is most often second guessed. Should I have held on? Should I have sold
sooner? Should I have scaled out? Compared to selling, buying is easy. For any
trader that uses technical analysis, buys are made when a pre-defined trigger
point is hit. “If this happens…buy.†Rarely do I hear traders second guess their
buy points. This is because whether a trader looks to enter on a breakout, a
pullback, a crossover, or some kind of oscillator signal, the rules are normally
well defined. To take the second guessing (and subsequent mental anguish) out of
profit taking, traders need to have sell rules as well as buy rules. The key is
to structure your sell rules in a way that you can comfortably follow them. If
you can’t comfortably follow them, you’ll end up breaking the rules and second
guessing yourself anyway.
The first thing to understand when determining
your profit taking rules is that you are never going to sell at the top. There
is no method that will consistently allow you to get out at the very top of a
move. That’s reality. There are two ways to deal with it:
1) You can sell too early
2) You can sell too late
These are your only choices. Today I will talk
about the pros and cons of each. Next week I will expand on this theme and
discuss how it is possible to mix methods to achieve your ultimate comfort
level.
Selling too early
Traders whose sell disciplines call for them to
sell too early never wait for a confirmation that a top has been made. Instead
they look to take profits either when certain targets are hit or the trend’s
momentum begins waning. Here are some things to consider when using a “sell too
early†discipline:
Pros
1) When selling too early it is much easier to get a good fill. This is
especially true for larger positions. Unloading stock is a lot easier when the
price is moving up than when it is moving down.
2) By selling too early, your account will be less subject to large drawdowns.
You’re not waiting for the top to confirm itself and therefore won’t have to
suffer through watching a position that was once a big winner reverse and stop
you out for a small gain or loss.
3) Your capital will be hung up for shorter periods of time. By taking your
profits earlier rather than later you can put that capital back to work in your
next trade.
Cons
1) You are significantly reducing the chances of a “home run†trade. If after
you sell the security continues to move in your direction, you will miss out on
that part of the move. This can be especially notable on big moves.
2) You will be more prone to shakeouts. A “sell too early†mentality frequently
means using profit targets and tight stops. The tighter the stop, the more
likely you will be shaken out of a move before its completion.
I know of many successful short-term traders that
use the “sell too earlyâ€. Their methods call for them to take profits as certain
targets are reached, and continue to scale out as the position moves in their
favor. While entry signals can catch major market swings as well as minor market
swings, the “sell too early†discipline doesn’t permit waiting around to see if
the swing will be major or minor. Rather they will take what the trade gives
them over a short time period and then move on to the next trade — happy to have
a decent gain.
Selling too late
Traders whose sell disciplines call for them to
sell to late are looking to make sure that that they ride the trend for all it
is worth. They don’t want to see their position go on to huge gains without them
and will do what is necessary to ensure that the move is over before they exit
their position. This is most commonly achieved through the use of trailing stop
techniques. Here are a few pros & cons to consider about selling too late.
Pros
1) “Home run†potential. It’s impossible to know how long a trend will last.
Some trends can last a long time and allow an investor to realize incredible
gains. Traders who decide to adhere to the “sell too late†discipline have a
chance to make huge profits on any trade.
2) Less prone to shakeouts. By using looser stops you will be less affected by
all the noise and more likely to be able to hold a position throughout its move.
Cons
1) Subject to larger drawdowns. Sometimes a stock can fall pretty far before a
top can be confirmed and the previous trend declared dead.
2) Capital is hung up for longer periods in each trade. Sometimes it can take a
very long time before it can be determined that a position has topped out.
During this period of time, you would normally be better served to have your
money invested elsewhere (or in cash).
3) Sometimes difficult to get a good fill. If your stop happens to be placed
near the stops of a lot of other people your chance of getting a good fill are
significantly reduced. This is especially true for large positions or thinly
traded stocks. Due to this, your trades will have higher slippage costs.
“Sell too late†is popular with intermediate-term
traders. They will never sell at the top, but will capture a large portion of
the move and will realize fantastic gains on some trades.
There is no right or wrong here. You can sell on
the way up, or you can sell on the way back down. You can make money either way.
What’s difficult (near impossible) to do is consistently make money by
arbitrarily selling without a discipline in place. I’ll expand on these thoughts
and discuss some of my preferences for taking profits shortly in my next “when
to sell†column.
Until Wednesday…good trading,
Rob Hanna
For those who may be looking to expand their
knowledge beyond just market timing, my
Hanna ETF Money Flow System utilizes the VIX in generating trading
signals for spread trades.
Rob Hanna is the principal of a money
management firm located in Massachusetts. He has spent the last several years
developing and refining methods for trading in stocks across multiple time
frames. He selects stocks using both fundamental and technical criteria, and
then trades them using technical analysis techniques.