A common question I am asked is, “When do you sell the stock you own?” There are several circumstances that need to be considered in answering this, not least of which are tax issues specific to the situation of the individual investor. I recommend everyone research how taxes affect their selling decision before acting. For this article, I will not consider tax specific considerations but instead focus on the simple expectation for the future direction of the stock and how to gauge whether it is the right time to sell.
When selling, there are two scenarios; selling with a profit and selling at a loss. Most investors would rather not think about the latter, but it is perhaps a more important action to take than selling a winner. Let me focus on selling losers first.
Why is it so important? Simply, there is too much uncertainty in investing. This means we are never going to be right all the time with the stock trades that we take. Losses are a part of investing and need to be controlled. We can’t control if they will happen; they are inevitable. However, we can control how big they are and the impact that they have on our total portfolio performance.
Before you buy any stock, establish a floor price that, if broken, will make you exit the position. The difference between that floor price and the price you pay is the risk of the trade. Divide that amount in to the amount you are willing to risk determining the number of shares you can buy. So, if you are buying at $10 and the floor price is $9, you are risking $1 per share. If you are willing to lose $200 on the trade, buy 200 shares. If the stock falls below $9, get out and move on.
It is important to establish the floor price properly and not base it on an arbitrary measure like percentage downside or how much you are willing to use. The floor must be established by the market itself and previous price levels that the buyers and sellers in the market have established.
Below is the chart of Toronto Dominion Bank, TD. It broke a downward trend line a couple of weeks ago, at the green arrow, setting up for a good (but not great) buy signal. I have drawn the downward trend line in red, the entry point at the green arrow and the floor price in green.
The floor price is set at the point where the stock most recently bottomed and started higher. This was the point where the buyers took control, the point when they said, “based on all of the information we have, this is the lowest price we can allow the stock to go down to.”
That is an important level because, if it is violated soon, it implies that there is some new and negative information that justifies accepting a lower price. It makes sense to establish this as a loss limit point because a move below it represents a win by the sellers in the never-ending war between then them and the buyers:
Sell stocks at a loss when the close below a well-established floor price that represents a loss of control by the buyers to the sellers.
When do we sell a profitable trade? We use a similar concept in that we should plan to exit a winner when the buyers lose control of the stock. For a stock trending upwards, this is best signalled when the upward trend line is broken
I have been a Bull on Bombardier (T.BBD.B) for some time but that changed today because the upward trend line was broken after the formation of a falling top. That means the buyers are tired and not motivated to continue to pay higher prices for the stock. The sellers are gathering momentum:
This pattern implies that there is a 70% chance that the stock will not achieve new highs soon and has a good chance it will move lower. A good sign to sell a stock that has performed well in recent months.
Selling is tricky because our emotions get involved. We don’t like the pain of taking a loss and we have a fear of missing out on more profits if we sell a winner that might continue to go higher. To be successful traders in the long term, we must play the probabilities. When stocks break down through an important floor, take the loss and move on. When a strong stock breaks its upward trend line, take profits and look for new places to place the capital.