Knowing when to sell our winning trades is one of the more difficult skills in trading. Human emotion leads us to make mistakes when making our trade exits. The fear of having a winner turn in to a loser will cause some to exit too soon. The human hindsight bias will cause others to hang on to a weakening stock with the hope that it will go back up to the higher price it was at before. Sometimes we just want to sell a winner because it makes us feel good, only to despair as the winner continues higher and higher.
If you pay attention to what experts are saying about a company, it is almost always the case that the story sounds its very best right before the stock tops out and starts to go down. Stocks that have made considerable gains but are destined to reverse do so because investors are all on the optimistic side. Anyone who is going to buy has bought and the trend runs out of fuel to continue higher. Therefore, listening to the story and falling in love with your stocks is a good way to miss the best exit signal.
Human judgment is flawed because of these emotional traps, so I have found it better to take a mechanical approach to the selling process. I want to rely on rules rather than gut feel, taking an evidence based approach to selling. If a series of criteria are satisfied, it is time to sell the winner and take profits off the table.
To teach you the basics of when to sell, I must first define what an inflection point is, a simple but very important concept in how I analyze charts.
An inflection point low occurs when a stock that has been going down stops going down and starts to go up again. Looking at stock’s candlestick chart, it is characterized by the candle that has at least four candles to the left and three candles to the right that have higher lows. As always, this is easier to understand with a picture:
At each of the blue arrows, you can count at least four candles to the left of the blue arrows that have lows that are higher than the candle at the blue arrow. There are also three candles to the right that have higher lows. The result is the formation of a point on the chart that shows where the stock stopped going down and started going up. These are inflection point lows.
A stock that is trending upward will always have short periods where it moves down. Investors who bought at lower prices are motivated by their emotions to take profits, even if the fundamentals of the company remain strong. Ultimately, an upward trend is defined by a line drawn across its inflection point lows and a down trend is defined by a line drawn across its inflection point highs. Below is a chart of Encana (T.ECA) which has been in an up trend since the Spring of 2016 when its downward trend line was broken:
Notice that each pull back in the stock over the past 9 months has never broken the green line that I have drawn. This is a healthy upward trend. Contrast that with this chart of Valeant (T.VRX) which had its upward trend line broken in September of 2015:
This should lead you to the conclusion that winners should be sold when their upward trends are broken. This is true, but it requires that we make sure to define the upward trend properly. Most upward trends will have pull backs along the way that seem to break trend if you take too short term of an approach.
To combat these potentially false signals, another helpful rule is to also look for the formation of a falling top around the time of the upward trend line break. Notice in the Valeant chart above that I have drawn two short horizontal red lines with the one to the right lower than the one on the left. This shows the formation of a falling top, a sign that the buyers are getting tired and the sellers are taking control of the stock.
Waiting for a falling top helps us stick with a winner despite short rounds of seller strength. Below is a chart of Teck (T.TECK.B), one of the top performing large cap stocks in Canada in 2016. It has been moving lower over the past month but it has not yet broken its upward trend line and has not yet formed a falling top:
Sometimes, the buyers will get so enthusiastic about a stock that they chase it higher with emotional buying. This causes a parabolic upward trend, one that curves higher with a steepening trend. A simple rule to keep in mind is that parabolic trends usually pull back to their linear upward trend lines, as happened in the chart above.
A more aggressive approach to exiting winners is to sell them on the first sign of weakness when their trends go parabolic, running up and away from the linear upward trend line. Here is a chart of Nvidia (NVDA), a strong performer from the Nasdaq:
Notice that the trend line I have drawn is not a straight line but, instead, a curve. Also notice that last week, it hit a new high but closed down and below the open for the week. That is something I call a Bursting Bubble signal, a good sign that the stock is going to see a period of profit taking. Although the media has been recently reporting a lot of what is great at the company, I would avoid Nvidia right now because the chart shows me that a lot of positive fundamentals have been priced in to the stock and the buyers have been chasing it higher with emotion. The risk is not worth the reward right now.
Trading is simple, but it is not easy. Our human emotion is what brings difficulty. Keeping it simple with a mechanical assessment of the chart using these techniques can help you hang on to your winners until they are likely to reverse.