Rules for Selling

Some investors seem to spend most of their time deciding what to buy. They should probably be spending an equal amount of time thinking about when they will sell. This might be uncomfortable because some investors associate selling with being wrong.

The idea of selling losers is well known in stock market trading. There is the famous saying of “let winners run and cut losses quickly.” This idea is sometimes applied only to the initial purchase.

Many investors are familiar with the idea of a “stop loss” which is a sell order that kicks in when the price falls by a predetermined amount. This is why some associate selling with losses. But, investors should actually have a plan for selling both losers and winners built into their stock trading philosophy.

The First Rule of Selling

Another reason investors might be hesitant to sell one of their stocks is because of Warren Buffett, one of the world’s greatest investors known for his homespun wisdom. Buffett has said his favorite holding period is forever and he has famously held his position in Coca Cola for years.

Well, this brings us to an obvious point but one that some investors fail to fully understand. They study Warren Buffett and strive to become like Buffett. This is an admirable goal, but…

The first rule of selling for real stock trading is to understand that we, as individuals, are not Warren Buffett so we need to be prepared to sell.

We do not have multibillion dollar tax liabilities to think about like Warren Buffett does. We are not privy to insider information that makes selling more difficult since there are rules about insider selling. We also don’t have access to billions of dollars in trading capital.

The truth is Buffett doesn’t need to sell something in order to raise capital to buy something else. He does have to think about taxes because his capital gains taxes could destroy billions of dollars in wealth. He claims he likes to “buy and die.”

And, even Buffett doesn’t hold everything he buys forever.

Buffett actually sells frequently. Every quarter, he files a statement with regulators that shows some amount of buying and selling. When he’s wrong, and he has been wrong, he sells. This is one of the reasons he is a great investor and it is one lesson we need to learn. We need to sell when we are wrong.

That brings up the question of how to know when we are wrong. One common and very workable answer is the stop loss. A stop loss order will automatically be executed when the price of a stock falls by a certain amount. Investors might set a stop loss at 20%. Short term traders might use 8%.

Let’s say you buy a stock at $100. If you set a 20% stop loss, the stock will be sold if it falls below $80. You might still like the company, and you can always buy the stock back later. But, the truth is that if a stock falls by 20% soon after its bought, it’s unlikely to deliver a big gain in the short run.

Large losses are simply difficult to overcome. This is because the math of losses is asymmetrical, or a bit lopsided. It always requires a larger gain to offset a loss.

A 20% decline, for example, will require a 25% gain to get back to breakeven. A 50% loss will require a 100% gain to get back to breakeven. And, a 90% loss requires a 900% gain just to bring your position back to where it started. There are few 900% gains so it is important to sell losers before they grow.

That table shows the difficulty of overcoming losses. If your stock declines 90%, it is unlikely it will gain 900% in the near term. A 99% loss is unlikely to ever be recovered.

Stock Trading Requires Selling as Well As Buying

While it’s easy to see the reason that losses must be sold, it might not be as apparent why winners will need to be sold. There are times when winners will not need to be sold. That’s the case when a stock continues moving up and the fundamentals of the company remain unchanged.

But, many stocks, it seems fair to say that almost all stocks, will eventually stop going up. Even Coca Cola stopped going up for more than a decade.

KO

 

Here is where many long term investors find reasons not to sell. They may point out that the stock still paid a dividend. They may point out that eventually the stock resumed its uptrend. They may also point out they avoided capital gains taxes. Let’s address each of these points.

KO did pay a dividend. That, however, amounts to a relatively small return of less than 5%. The goal of stock trading is beat the market which means it is important to think in relative terms. It’s not enough to have a gain for successful stock trading. It’s important to have better returns than the market. That means simply collecting dividend is not enough.

KO did eventually start moving up again. But, not all stocks will. And, while waiting for the resumption of the up trend, you are sacrificing potential gains that are available in other stocks.

Finally, the buy and hold investor did avoid taxes. But, again, they gave up potential gains in other stocks. In “How to Make Money in Stocks” William O’Neil gave a rule about taxes for stock trading:

“Make money first. Pay taxes second.”

Taxes should rarely be a consideration for most individual investors. That will lead to decisions unrelated to the company and we are really trading a stock, not a tax bill.

To decide when it is time to sell, an investor can compare their stock to the market. For a long term investor, if the stock lags the market for more than a year or two, that indicates there are better opportunities available.

For a short term investor, the time could be reduced to 3 to 6 months. Remember, with stock trading, the goal is to beat the market, not just to match the market.

Selling Based on Fundamentals or Technicals

Fundamentals could also be used to time the sell decision. If a company reports a decline in sales or earnings or other fundamental data changes significantly, it is no longer the same company you could bought. That means it should be considered for selling.

Technical analysis of stocks is ideal for making the sell decision. The next chart shows a support line and a trend line. A break of either one of those lines could indicate the direction of the trend has changed. That could be a reason to sell for technical stock trading.

SPY

Finally, the stop loss could be modified to time the sell.  After a stock moves up, the stop loss could be moved up. This is called a trailing stop. For example, if buying at $100, when the stock reaches $125, raise the stop to $100. Keeping the stop 20% below the high is one simple way to implement this.

Selling is critical for most investors. If you are concerned that you don’t have the discipline to follow sell rules, consider using a service.

The Stock Trading Tips service, PPK System, is designed to exploit patterns associated with market clues by looking for value and momentum in stocks. That’s the combination many researchers found beats the market. It has strict rules for buying and selling. You can learn more about this trading service by clicking here.