By Brian Shannon
In the July 2003 issue of SFO Magazine I wrote an article that explored the dynamics of a short squeeze and the factors that should be considered when entering a stock trade from the long side. In this article we examine the elements that should be considered when exiting a trade. Referring back to the stock outlined in July (good potential short squeeze candidate Odyssey Healthcare), we will see where that trade should have been exited using a timeframe appropriate for position traders (1 week to 6 months typically). We will also study when the appropriate time is to exit a swing trade (1 to 10 days typically), as well as looking at a unique way of exiting a profitable day trade.
It is often said that entering a stock is easy, but knowing when to sell (or cover a short) is what separates the best traders from those who just scrape by. Any successful trader knows that having an exit strategy is the true key to consistent success in the markets. As with any decision in the market, it is easy to let emotions creep into the decision making process. If a trader allows feelings to become a factor in making decisions, he will find the emotional battle from within paralyzing at times. Some of the questions that will creep into our minds include, “Do I sell now and take a small loss, or do I buy more to average my price lower?” and “Should I sell for a small profit, or should I hold out for bigger gains?” These are just a few of the questions traders ask themselves when faced with a decision to close out a trade. Clearly these emotions are going to get in the way of making objective decisions, so we must have a disciplined and consistent plan of action that cuts losses at an early stage and allows our profits to run. This plan of action is based on the single most factor, price action. In reality, knowing when to exit a position can be an agonizing experience to the undisciplined trader, especially when trading larger share size.
Traders must recognize that the market does not care what any of us think the stock should do. At the end of the day, our opinion does not count. Buying or selling a stock casts our vote of confidence for that security, and in the market our opinion is about as relevant as if we had voted for Al Gore for President. Therefore, we must always remember to leave our egos at the door and trade according to price action, not what we believe.
Before we get to specific strategies, it is important to consider the futile nature of trying to find the single best way of exiting a position. We need to recognize that there is no single best way to do anything in the market because we all have different objectives in terms of time in a trade, different risk tolerance, as well as funds within our account. We also have to take into consideration that a successful trader will often implement multiple strategies encompassing different timeframes and varying objectives in the same account to gain a diversification in his income stream. Certainly the objectives of someone who is a pure day trader will be vastly different than those of a more patient individual who may be comfortable holding a position for months at a time. With that in mind, we will examine seven good reasons and strategies to exit a position. By having a solid understanding of these seven incidents of market action, we are in a position to sell based on an objective interpretation of the message the market relays to us in the form of a price chart. For simplicity we will refer to the long side of the market in all of the examples; however, it is important to recognize that these events are valid on the short side by simply reversing the rules.
There are seven events that should motivate you to sell. These events can be best described as:
Initial Protective Stop
Gaps against the prevailing trend
Hard Trailing Stops
RealTick ® Trailing Stops
Moving Average Crossovers
Initial Protective Stops give us our first decision to sell because they are based on the interest of preservation of capital. Before we ever think about taking profits, we have to ensure that we are in a profitable position. Long before we are in a profitable position our stock has to pass an initial test of strength. The nature of short-term trading is to be in a position only while the stock is showing positive momentum. Positive momentum means that the stock is moving in the direction we anticipated (we can have positive momentum in a stock that is dropping if we are short the stock). Once a stock shows signs of reversing its momentum, swingtraders should be out of that position and in cash, or else in another stock where their money is working for them
The final judge as to the success or failure of a trade is price, and it is therefore the most important consideration in when to exit a position. Price action is the building block upon which support and resistance are formed, becoming the bedrock of trends. The goal of a trader is to capture as much of a trend as the market allows for, and this is why price is our most important source of information. The first time that price plays a role in our decision making process is in setting an initial protective stop on the position. Before thinking about how much money a trade will make, we need to consider where we will exit if the trade does not go according to plan. By having a protective stop on a trade, we will not succumb to holding a position because we “think it is a good idea”. Removing the emotion from the decision making process allows us to be completely objective in our analysis of the progression of the trade.
When initially entering the trade, the first technical consideration is the location and price levels of support and resistance. Besides making sure we are entering a position that is not too far extended from a decent level of support, the reason we immediately look for support and resistance is to set a protective stop. We place the initial stop to make sure that if the stock does not act the way we expected it to, our accounts are not exposed to a catastrophic loss. For longs, stops should be placed just below the most recent support, and for shorts stops should be placed just above a recent resistance level. Obviously, if it is not a swing trade, a shorter timeframe should be utilized to determine this protective level. In the case of ODSY, the stock was shown after it broke out to all time highs on May 6, with the price at the time $17.60 (adjusted for a 3/2 split on August 12). At that time, the highest preceding low was found at the April 30- low of $15.73, coinciding with the location of the rising 50 day moving average. Whenever we have more than one technical reason for being involved in a trade it adds significance to the level. In this case we had what appeared to be the beginnings of a new uptrend with the prior low and the rising 50 day moving average in the same location. Just below the prior higher low is often the ideal point to place our initial stop because breaking below that level would nullify the trend. In essence, we are exploiting the definition of an uptrend (higher highs and higher lows) to remove the dangerous emotions to be allowed to enter our decision making process.
Gaps against the prevailing trend occur when a stock in an up trend suddenly gaps lower while you have a long position in the stock. Luckily, these gaps in trading caused by an imbalance to the sell side while the stock is in a solid up trend are not that common. We are not discussing common gaps of 1-2% here, but a gap down by more than 5%. When we do find ourselves in the unfortunate situation of being caught in this predicament, it is often best to sell the entire position. A gap of this magnitude (5% or move) will not typically occur unless there is a serious fundamental development at the company, and since our entry may not have taken fundamentals into consideration, we are now in a position that we were not anticipating. As they say, “When in doubt, get out!” As a general rule of thumb for gaps, liquidate the position if a hard stop (sell event number 4) has been violated. If the stock gaps down 5% but does not violate a hard stop, we need to monitor the stock closely for further signs of weakness. If it looks like liquidity may be an issue for exiting a larger position, it is a good idea to consider selling half of the position so if the weakness continues you will not feel trapped in the stock as it declines and grow reluctant to sell, waiting for a bounce that may never arrive.
We can see in the chart of RSA Security that the stock gapped lower on October 17 and did not bounce. Although it would have been a tough decision to liquidate the position on such a gap, it is clearly better to have sold at the first sign of trouble than it would have been to continue to hold and hope. Sometimes it is best to get the pain over all at once by selling the entire position rather than prolonging the agony of a loser, similar to removing a band aid from a wound, as slowly peeling a band aid only extends the discomfort.
Price Targets. It is a good idea to have a reasonable expectation as to where you think the stock has the potential to rally to; thus coming up with an estimated area where selling may occur. If our stock is in a solid uptrend that may be approaching a prior level of support, there is the potential for that past area of buying to offer resistance. Assuming you started with a good theoretical risk/reward ratio in your original purchase, taking some of the profits makes sense at the target area. But also be careful not to sell too much of a stock that continues to have strong upward momentum because the biggest gains are likely to still be ahead in this situation. Selling a little at the target also helps make it easier to let go of the stock later because it shows we are not emotionally attached to the stock, and you’ve got to admit it feels good to take a profit and reward yourself a little. Taking a little stock off the position also reduces our overall risk and gives us a little cushion in case something unexpected happens to make the stock drop suddenly. For the rest of the position, hold on tight, and allow yourself to have a big winner. Bulls and Bears make money, Greedy pigs get slaughtered and Disciplined pigs get Rich!
Hard trailing stops require the most skill, but by the time we get to this point, the stock is doing the work while our job is to monitor and adjust our risk levels as the stock moves higher. A hard trailing stop is based on the very definition of the trends we are trying to take money from. As we know, the definition of an uptrend is “a series of higher highs and higher lows.” This implies that breaking the series of higher lows is a violation of the trend and that is a reason to sell. When looking at a chart that encompasses 17 days of trading utilizing 15 minute time increments, we can see how shares of Netflix Inc. (NFLX) ascended over the course of nine days in a perfect stair-step pattern of higher highs and higher lows. Assuming the purchase of the stock at $36.50 on October 2nd, we would have an unrealized profit of $4.41 per share based on the close at $40.91, and this is a gain that is definitely worth protecting. The accompanying chart of NFLX shows how the trader would have raised the stop up under the rising lows with an exit being made on October 8th as the stock traded below the prior low of $42.85. This stop would have allowed the trader to lock in a gain of $6.35 over the course of five trading days. This stop takes some work because you have to cancel and replace orders, but this is work that is fun because it means you are locking in profits. In order to capture the occasional windfall profits in a stock that exceeds the profit objectives, we use a simple methodology that has proven very effective for holding stocks that are showing positive momentum. The method for allowing our winners to run is to use a trailing stop-loss based on the higher lows that the stock is forming in the uptrend. Holding a long stock that is moving higher is done by using the daily chart and placing our stop just below the level of the last higher low. If the stock does not trade below the previous days low then it is showing positive momentum and should be held overnight again.
RealTick® Trailing Stops are my favorite stops to use on a day trade. This unique stop actually gives control of your order to the algorithm built into the RealTick trading platform. The ideal situation to use a trailing stop is when you buy a stock that finds rapid upside velocity, pushing the stock quickly away from your hard stop. In the situation where the stock may run $1.00 or more in just a few minutes we are faced with the dilemma of deciding whether to sell the position and lock in the gains or to allow it to run further. We’ve all seen the stocks that can run 2-3 dollars in the course of an hour or less, and we certainly don’t want to allow a nice winner turn into a loser. The emotions that can be dredged up from this experience tempt event the most disciplined traders to exit with the profit rather than allowing it to run further. These stops are going to be utilized most often within the first hour of trading, when emotions from the amateur buyers are often at an extreme. Fortunately, technology has taken given us the opportunity to mitigate the emotional decision process with the Real Tick trailing stop.
This stop works in the following way, we will refer to chart four here. On August 21 Semtech started to rally late in the afternoon and I bought 1000 shares for a quick day trade. The stock continued to progress nicely higher, and because it was showing strong positive momentum and displayed a strong technical pattern, I locked in partial profits on half of the position and allowed the rest day to be transitioned into an overnight hold. The stock closed that day at 18.58. The next morning the stock gapped higher at 19.11, and at this point I was tempted to sell the stock for a quick profit of $265, but decided instead to allow the profits to run a little. When the stock was at a price of $19.28 I entered a trailing stop of $.15, which is read on the Archipelago Exchange as a stop market order at 19.13. As the stock exhibited further strength the stop automatically gets adjusted higher, but it will never get adjusted lower. The trailing stop sets an actual stop $.15 (or whatever increment you choose) below every new high the stock makes. Keep in mind that this will turn into a market order upon the stop getting activated and this can cause slippage in illiquid or fast moving markets. As you can see from the accompanying table and the chart, over the next 23 minutes the stop was automatically adjusted 157 times until the trade was finally stopped out $1.79 higher than the original stop. That is an extra $895.00 made on the trade without any further intervention on my part, and a total profit for the day of $1160.00, and to think that I was tempted to sell at the open for just $265.00! Ideally I would love to use a trailing stop on all my trades because it means I have gotten into a stock at a time of maximum upside velocity.
The most difficult decision for a trailing stop is how much room to allow the stock to have. I think it is sort of like going fishing. If you have a big fish on and you tighten the line too much the fish is sure to break off and you never get to taste your reward. In trading, if you set the stop too tight you might get shaken out of the position before the stock runs its course. How much room I decide to give a trailing stop depends a lot on historical volatility and the price of the stock. The more volatile and higher priced stocks will need to be given extra room to wiggle while less volatile lower priced issues can usually be kept on a tight leash with just a $.10-.15 stop.
Moving Average Crossovers often signal the end of a prevailing trend and that is a good time to take profits on a position. For this example we will refer to the chart (3) of Odyssey HealthCare (ODSY). Referring to the July article, the stock was purchased in early May near $17.50 (adjusted for a 3/2 stock split on August 12) with the hope the market would allow it to be a position trade because of all the positives the stock had, position trades typically last from a week to as long as six months.
Trending stocks tend to stay above the rising moving averages, and ODSY remained in a healthy up trend that would pause briefly at the 10 and 20 day moving averages where it would find fresh buyers to bring the stock higher. On September 22, the stock broke hard down to the rising 50 day moving average. This swift sell off was reason for concern, but not yet a reason to sell as stocks often find support at the rising 50 day MA. Three days later, the stock experienced another wave of selling and that brought the 10 day MA down through the 20 day MA, this action tells us that the short term trend was now heading lower while the intermediate term was trending higher, this indecision tells us it is time to book profits. The stock was at $28.50, well off the high near $36, but still 62% higher than the purchase just four months before. That is how this type of stop can get us out of a position, now let’s examine why.
Moving averages are simple, but often misunderstood, technical indicators. I like moving averages because they allow me to objectively identify trends on all timeframes with incredible accuracy. One of the common misconceptions about MA’s is that moving average crossovers are a reason to enter a position, I have found that moving average crossovers occur in a sideways consolidating market and it is difficult to determine when these consolidation periods will end. Understanding that moving average crossovers represent indecision because there is no longer a consensus of agreement about whether buyers are sellers are in control allows us to recognize the value of the first crossover at the end of a trend as a reason to sell. Usually a moving average crossover occurs after a trend has exhausted itself, and as trend followers there should be no clearer sign that it is time to exit gracefully with our profits before the market relieves us of them.
Time Stops are a way of exiting a position that is stagnant. As traders, we encounter two forms of risk, the previous six reasons to sell addressed the risk of price. This stop addresses our other form of market risk, time. Time can be our biggest enemy in a trade; it can be the quiet killer of our equity. How many times have you neglected a stock in your account because it wasn’t doing anything? Even a day trader will sometimes find himself complacent with a stock that doesn’t show any movement, and then suddenly a sell order comes into the stock and moves it lower by a dollar without us having the ability to react. The time stop takes care of getting out of a position if it is not working as quickly as we would have expected. The general guidelines that I use as time stops for day trades is 15-30 minutes, with more emphasis on 30 minute level if the overall market is moving in the direction anticipated for the stock. For a swing trade, I will typically give the stock 2-3 hours before moving before I consider selling the position out near my cost basis. For position trades, my patience gets stretched easily and I will give the stock no more than 1-2 days to get moving before I start to think my timing is off. When I get stopped out because of time, I will often re-enter the stock if it exhibits signs that it may be ready to move later on.
These seven reasons to sell are not meant to be the only reasons to exit a position, but hopefully it does give you something to think about when you look at closing out your positions. Keep in mind that the there are many different situations that present themselves to us in the markets and the more strategies we have to take advantage of them, the more likely we are to attain our goals being in the elite group of who consistently take money from the market.