To Sell a Stock or Hold--When Is it Time?
Should you use the strategy of the long-term buy-and-hold investor or the short-term sell tactics of the trader in order to lock in small gains? The answer is not simple. Twenty years ago, it was relatively easy to categorize oneself as a trader or long-term investor. In recent years, the issues have been made more complex by the amplitude of market swings. Let us look at a few alternatives and possibly a strategy..
In the chart of Pfizer below, the lines at the bottom relate to the stock’s "relative strength," and can be ignored for the purposes of this discussion. Also ignore the broken line that closely follows the stock’s price action.
The straight line that begins at "A" represents a line of buying support for the stock. When the stock touches this line, new buyers enter the market, driving the stock to higher levels. As you can see, once the stock moves to this higher level, people begin to sell in order to take their profits off the table. This drives the stock back down until it encounters new buying support. In my earlier days as an investment advisor, once I identified a rising line of support like the one above, my purpose was to buy at points like "A" and let the stock run until the line of support is violated. This is the way most technically oriented professionals use lines of support. However, let's look at this a little more closely.
Suppose the stock is bought at point "A." The stock rises to point "B" then declines to point "C." Now, there is no assurance that the stock will rise to point "D." Instead, support could break down at point "C." In a volatile market such a breakdown could plunge the stock well below our purchase price within a single day. Suppose we bought Pfizer at "A" in the chart (and that we bought it with the intent of keeping it until it starts to break down). Assume that after reaching "H" the stock returns to the line of support (there should be an "I" where the stock touches the line). The price at "A" was 31.625 per share. The price at "I" was 43.1875 per share. Now assume the support dies away and the stock drops. When this occurs, it is sometimes only a temporary sell-off, and sometimes it is not.
Assume for the sake of this illustration that our tolerance for a stop-loss is 15% (This is a common practice for investors who hold 15 or more stocks in their portfolio, but it is far more than most traders would tolerate. Nevertheless, the lesson is pertinent to both groups). Assume that the stock then drops 15% below point "I" and we sell. Now, what has happened? We bought at 31.625 and we sold at 36.70 for a gain of about 15.75% after commissions. That is not bad for little more than two months (we bought on 3/8/00 and sold on 5/23/00). However, the stock’s pattern could have broken down at point "C" resulting in a loss. It could also have broken down at points "E" and "G."
What does all this mean? It means that in a choppy or volatile market, we can have no assurance that any trend, no matter how well defined, will continue long enough for us to profit if we maintain a buy and hold mentality. While it is true that if we hold long enough many losing positions will eventually become profitable, it is also true that the time it takes to realize a given profit is extremely important. A profit of 8% in one month, for example, represents far better performance than a profit of 20% in a year. Of course, this assumes that the 8% a month can be achieved more than twice during the year.
Let us return now to the chart and consider another scenario. Assume we decide to sell whenever the stock rises 10% above our purchase price (perhaps our rationale is that any time we can gain 10% within a three-month period, we are at that point annualizing over 40% and we should lock it in while we have the chance). In this case, we would buy at "A" for 31.625 and sell at 34.78. After we sell, the stock would climb to 35.25 before declining. We do not know how far the stock will drop, but we have taken a 10% profit off the table. It took only two days to get this 10% (we will net about 9.75% after paying brokerage commissions for buying and selling). We could buy again at "C" for 34.25 and sell at 37.675 for another net gain of 9.75% (the stock continues rising to $40). We might also buy a third time at "E" for 36.875 and sell at 40.56 for yet another 9.75% net gain (afterward, the stock rises to $44.25).
Assume that because the stock did not touch the line at point "G," we invested in a different stock to get our fourth gain. By now, we have a net gain of about 43.9%. In the process, we have reduced our risk. Why? Because whenever money is still on the table it is exposed to potential loss. In this approach, we have taken money off the table part of the time, and we have locked in profits before the market has taken them away. Now, assume we bought again at point "I" and the stock drops 15% instead of rising, triggering our stop-loss just as it did under the other scenario. If we lose 15% on this trade, we will still have a net gain of 22% over the two-month period. Thus, we have greatly increased our net gain while reducing our exposure to risk.
The amount of gain set for our selling target would depend on the prior behavior patterns of the stock and on the stock’s behavior during the time of our investment. The concept here is not that we would necessarily sell every position after a predetermined gain, but that in many cases we might sell preemptively. Here is how I might rationalize a quick sale. I consider a return of 20% over a one-year time frame to be a decent return for investors who ride out the ups and downs most of the time. For short-term traders, our target would probably be at least two or three times that amount. Imagine a stock rising smoothly in a straight line from $100 to $120 in a year. For the purposes of this discussion, consider this to be the model for our "ideal" stock. Try to actually visualize a chart of our "ideal" stock.
Now suppose we overlay a plot of the growth of our real stock on this same chart. At some time our real stock may rise above the smooth line of ascent of our ideal stock. Whenever our real stock is above our 20% target line, our real stock is giving us a higher annualized rate of return than our "ideal" stock. It’s at times like this that I would consider locking in the higher growth rate and moving on to another situation. My reason is that locking in 10% in less than a quarter is more appealing than risking that gain by holding for another three-quarters of a year for the possibility of getting an additional 10%. However, I would not necessarily sell immediately. I might be inclined to place a stop-loss just under the stock. If it continues to rise, I would follow it up with a close stop. Eventually, the stock will "twitch" the wrong way and I will be out of the position with a very nice return for the time invested.
Why sell just because the rate of gain has surpassed some targeted rate? Never forget that periods of price acceleration are usually followed by an unwinding of the acceleration’s gain. When a stock returns to its rising trendline, it is much more likely to surge in price because that trendline represents support. When the stock begins to bounce off this support (because of the extra buying pressure along that line), a trader may infer that the stock "wants" to rise. That, by the way, is characteristic of a "setup." A "setup" is a pattern of behavior that often precedes a surge in price. Our stockdisciplines.com traders have learned through experience the importance of weighing the probability of a gain from the current price against the probability of a decline. When we have this kind of configuration (a stock declining to its rising trendline and then starting to move up after touching it), the probabilities are aligned in our favor. In other words, we look for setups because they are pregnant with upside potential. Once the stock has moved and achieved a nice gain relative to the holding period, the probabilities are no longer aligned in our favor (the potential upside energy has been dissipated in the rise of the stock). The stock will not go up forever. Instead, the probabilities favor a decline. You can patiently sit there while your gains evaporate, or you can take them off the table until you find another setup.
Dr. Winton Felt maintains a variety of free tutorials, stock alerts, and scanner results at www.stockdisciplines.com has a market review page at www.stockdisciplines.com/market-review has information and illustrations pertaining to pre-surge "setups" at www.stockdisciplines.com/stock-alerts and information and videos about volatility-adjusted stop losses at www.stockdisciplines.com/stop-losses