Most trading and investment books teach you when to buy. “Buy when indicator XYZ is very oversold.” “Buy a stock that has strong corporate earnings growth”.
But few books teach you when to sell. Closing a position is just as important as starting a position. If you close your position at the wrong time, you can easily turn a profit into a loss or a large profit into a small profit. Knowing when to sell your position depends on your trading or investment strategy.
You must have a pre-determined exit strategy before you start any single trade/investment. Here are several methods for closing your position.
*We are assuming that your position is profitable right now. This post covers The best stop loss for an investment or trade.
Some traders like to scale out of their position and take profits on the way up. Here’s an example:
- They buy stock XYZ at $100.
- The stock goes to $120. They close 1/4 of their long position and make a 20% profit on this part of their position.
- The stock goes to $150. They close 1/4 of their long position and make a 50% profit on this part of their position.
- The stock goes to $200. They close 1/4 of their long position and make a 100% profit on this part of their position.
- The stock falls to $160. They close the last 1/4 of their long position and make a 60% profit on this part of their position.
This is the ideal strategy for trading a bubble (i.e. last leg of a bull market). The simple reality is that NOBODY knows how high a bubble can go. Nobody can pick the bubble’s exact top. Bubbles tend to soar above all rational price targets.
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So if you sell all of your stock at e.g. $120 and then the market soars to $200, you might panic, buy back the stock at $200, and then watch it crater to $160.
With a scale-out exit strategy, you always hold a little stock as the market is going up. This anchors your psychology and prevents you from buying at the top of the bubble.
Sell the entire position once it reaches a pre-determined target
Many chart traders have a pre-determined price target. E.g. chart pattern XYZ said that the stock will rise from $100 to $120. They close their entire long position once the price reaches $120.
This clean-cut exit strategy has an obvious drawback: nobody can pick exact tops and bottoms with consistent accuracy. What happens if the stock subsequently soars from $120 to $200? These traders will have missed out on massive profits.
This is the problem that most short term traders have. Their exit strategies prevent them from letting their profits run. The big money isn’t made by hitting a bunch of singles. The big money is made by hitting a few home runs. And the thing about home run trades is that you just don’t know how far the market can go. Having a pre-determined price target at which you sell everything is the opposite of letting your profits run.
A moving stop loss for profits
Trend following strategies use a moving stop loss to protect profits. This can be a simple moving average such as the 50 day moving average.
The drawback to this strategy is obvious. There are a lot f false breakdowns nowadays. Here’s an example.
- You buy stock XYZ at $100.
- The stock rises to $140.
- The 50 day moving average stop loss is at $130.
- The stock falls to $129, and you sell. You locked in a 29% profit.
- The stock then soars to $160.
You just turned a potential 60% profit into a 29% profit.
Wait until a clear countretrend signal has developed
This is the strategy I use in the Medium-Long Term Model. It is similar to my preferred Stop Loss strategy.
*This strategy only works in the U.S. stock market, which has an obvious long term bullish bias. The stock market is always going up over a 30 year time frame.
The Medium-Long Term model states that you should always be long stocks UNLESS
- The model signals that a “significant correction” is about to begin, or…
- The model signals that a “bear market is about to begin”.
The model states that you should always be long the stock market, even if the stock market has been swinging sideways for a long time. Given the stock market’s long term bullish bias, a long sideways consolidation merely increases the probability of a massive breakout on the upside.
The model is essentially looking for big counter-trend (against the bull market) signals. It doesn’t use a price-specific stop loss to protect profits. It doesn’t “scale out” in the way up. It doesn’t exit a position using a pre-determined price. The model simply says that you should buy and hold stocks UNTIL a clear counter-trend signal emerges.
I sell all of my stocks when the counter-trend signal emerges. The stock market might go up for a few months after the SELL signal emerges. But I know that the market will definitely be lower than my SELL $ once the significant correction or bear market is over.