Everything You Need to Know About Selling a Stock
Let's look at four ways to view selling stocks and see how to make them work for you.
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Last week, I discussed how professional investors are good at buying, but very poor at selling. An academic study found that most money managers would be better off if they sold stocks randomly.
The biggest problem with the selling decision is that most investors don’t sell until they are forced to suddenly make a decision. They haven’t engaged in any advance planning, so they end up making an emotional decision when market conditions shift.
Typically, the first stocks to be sold are the ones that have made the biggest move in either direction. That is a sign that the decision is an emotional one rather than based on careful analysis. There is a strong tendency to sell the names with the biggest gains first to protect profits, but quite often the stocks with the most significant gains are the best stocks and likely to run even higher.
There are four basic approaches to selling, and you can combine them in various ways to create a methodology that works best for you.
Long-term buy-and-hold investors like Warren Buffett use the first approach to selling. They only sell a position when there is a significant shift in fundamentals and their thesis for the stock has changed. The obvious problem with this approach is that there can be giant swings in even the best stock. Apple (AAPL) , for example, has pulled back more than 50% at times. If the thesis for holding stock is wrong, then you will end up sitting on a huge loss if you fail to admit a mistake was made.
The second approach is technical. Technical traders will use support levels, moving averages, and other indicators to signal that it is time to reduce a position. It is fairly common to use the 50-day moving average as a sell point for traders with an intermediate time frame.
A third approach is to sell into strength. This variation of the technical approach involves selling when overbought conditions are extreme and entry points are difficult to find. The problem is that overbought stocks often become even more overbought before correcting.
A fourth approach is to use trailing stops. It is quite common to set a stop at 7%-10% under recent highs and to keep moving it up as a stock continues to trend higher. The problem with this approach is that you will not sell at the highs, and it isn’t inconsequential to give back 10% of recent gains. Quite often, a stop is ineffective when a stock gaps down substantially on significant news.
My best advice is to sell incrementally and employ an amalgamation of these four tactics. For instance, if a stock becomes extremely extended, consider making a partial sale to lock in gains and reduce risk. A partial sale satisfies the emotional push to declare victory.
A trailing stop for a portion of a position works very well when you are making some sales into strength. This helps to preserve gains and allows a higher level of patience.
The most important issue to understand about selling is that it isn’t a permanent decision. You can immediately buy back a stock that you sold, and if you end up paying more for it, then think of it as the price of an insurance premium.
When making partial sales of stocks, I consider the overall chart pattern, fundamentals, and potential news catalysts. I will often reduce a position in front of an earnings report because of the elevated risk. I’d rather trade the volatility after an earnings report rather than bet on a binary event. Some of the best trades come when you buy a negative reaction to an earnings report that is being misunderstood.
Every investor will occasionally be hit with surprise negative news. Stocks often bounce back nicely, but in many situations, recovery can take a very long time if there is news with a substantial fundamental impact. My inclination is to try to get the stock off my screen, because it takes up my emotional energy and hurts my ability to trade if I dwell on it. I’d rather just move on, even if my sale doesn't turn out as well as I'd like.
One piece of advice I give to traders who are struggling is to sell everything and start with a clean slate. This allows you to escape the baggage of unrealized loss and look at things with fresh eyes. Your view of a stock will change tremendously when you no longer own it.
The selling decision is all about risk management. Selling is the most powerful tool that we possess as investors and traders, and most folks don’t use it enough. Think of it as just a way to adjust your position up or down as market conditions dictate.
My best advice about selling is to think about it before you do it. Make sure you have a strategy and plan, and stick to it.
At the time of publication, DePorre had no position in any security mentioned.
