There is an old rule in the market, often repeated by Jim Cramer on his “Mad Money” program on CNBC: “Bears win, bulls win, pigs get slaughtered.” This means that those who hold on to their stock to long end up losing money.
So, when you should sell your stock? Sell strategies are just as important as your buy strategy. It seems everyone has their preferred way to buy. Every investment newsletter lists stocks to buy now; your broker has her favorite “strong buy” list; your friend at work has his “can’t miss” stock to buy now; heck, even the taxi driver has their favorite stock idea. Let’s assume they are each right with their picks. You followed their recommendations and the stock has gone up. What do you do now? Do you keep holding, hoping it will continue to go up? Do you sell it all, or maybe sell some of it?
Well, these are all good questions, since you do not make any money until you sell what you bought. To bad none of these people told you when to sell. Up until now any gains you have are unrealized and exist on paper. Only when you sell do you actually realize any profits from your investments and trades. Now, if you only knew what to sell and when to sell it. Actually, there are five reasons to sell stocks that have unrealized gains:
The price has reached the predetermined target you established when doing your homework before you made your purchase;
The price drops back down to your trailing stop order that you have set according to your stop rules;
You need the money for some other purpose (to buy another more promising stock, to invest in some other asset or for some other good reason;
As a part of good capital management you wish to realize some of the gains and reduce your holdings of this stock; and
You have reached the end of the time you gave for this stock to perform and you believe there are better opportunities.
Today, let’s focus on setting your exit target. If you did your homework before buying your stock then you should have a good idea of the potential it has to grow. This means you went through a rationale process to set a target exit price. This target can be based on analysis of the financial statements and then project performance over a set period of time. You can also use one of several technical methods.
Fundamental Approaches
There are several ways to calculate the expected price per share of the stock including Discounted Cash Flow (DCF), a stock’s P/E ratio (Price Earnings ratio) or Earnings Yield, among others. Stephen Penman’s book Financial Statement Analysis and Security Valuation is an excellent source on understanding financial statements and then using them to develop stock valuations both present and future. It is a text book in many MBA programs. To his credit Dr. Penman does not focus on the accounting used to develop financial statements, but rather how to use them in your investment analysis and valuation.
Let’s look at a simple example. XYZ Corp’s revenue and earnings were growing at 20% per year, with current Earnings Per Share (EPS) of $1.50 and a PE ratio of 25 (stock is selling at $37.50). Based on your careful analysis, you believe the company will continue to grow revenues and earnings at the same or possibly higher rate for the next year. Multiplying EPS by the 20% growth rates gives us the forecast EPS in one year of $1.80, assuming no dilution in shares outstanding. You also assume that the PE ratio will not change over this year. As a result the value of the stock of XYZ is forecast to be $1.80 x 25 = $45. This is an 20% increase in the value of the stock, not surprisingly since the only variable that changes was the growth in earnings at 20%. Now, if your analysis showed that XYZ grew their revenues faster than costs, earnings would have grown faster than 20%, say, for the purposes of this example, 25%. You might have also decided that since earnings were growing faster the PE ratio would increase from 25 to 30. As a result, the value of XYZ in one year is forecast to be ($1.50 * 1.25) * 30 = $56.25, a 50% increase in value per share. A very nice one year return.
With these two forecasts for the value of XYZ Corp, you have bracketed the growth potential of the stock. This gives you a range to set your target exit price. You also can use the assumptions you made to help monitor the performance of the company, the sector and the economy. It is important to stay current on the company you own on a regular basis. I encourage you each week to spend 1/2 hour per week per stock reviewing recent press releases from the company and their competitors, the sector and the economy in general. You will become a more successful investor for it.
There are several things to keep in mind regarding these forecasts for the price on XYZ Corp. First, these are forecasts and they do not necessarily work out all the time. It is best to monitor the assumptions you made as time goes by to assess if your forecast is working as expected. Second, this projection in the value of XYZ stock is based on analysis of the company’s financial statements. Business conditions can and do change, sometimes for the worse. If you perceive a change for the worse, then it is best to close out your position. With today’s low cost brokers, you can always reestablish your position if the situation changes for the better. Third, while this type of analysis isn’t difficult, it does take some homework and time. It is best to try to keep your analysis simple, so you understand the key drivers of the business.
Technical Approaches
Your exit target can also be determined by using technical analysis. Some technicians use what they call the Measure Rule as a way to forecast their target exit price and as a result how much profit they can expect from a trade. The Measure Rule computes the difference between the highest high and the lowest low in the formation they are analyzing to give you the formation height. Then they add the formation height value to the highest high to get the target price for upside breakouts and subtract the formation height value from the lowest low to determine the downside target.
I know of no rationale explanation why the Measure Rule should work. However, since many technicians use this rule it is helpful to understand it and be prepared for some selling to occur at the measured target. I am aware of an article by Thomas N. Bulkowski that modifies the Measure rule by multiplying the result by the percentage that meet the price target based on his statistical analysis as presented in his book “Encyclopedia of Chart Patterns (Wiley Trading) “. This approach employs uses actual results to statistically set targets based on the past performance of the formation that is observed. Since it is based on the statistical performance of each formation in the past, this approach seems to work as predicted using the probability in the formula.
For more on applying statistical results please see Thomas Bulkowski’s web site here.
Other technicians set their target based on the next level of resistance they see in the chart pattern. Resistance is where the price reaches an area of new and increased selling that halts the rise in the stock. Often this is where some investors who have been in the stock for a long time will sell to either recoup their losses or to breakeven. It is also an area that traders may use to close out their positions after buying at lower support levels. All this selling causes the price of the stock to pull back. When setting your exit target, this resistance should not be considered a specific price, but rather a range. Often the price will not hit the exact former high, so it is best to use a range for your resistance area.
For example, using your favorite charting software, examine the chart for Earthlink, Inc. Assume you knew to buy ELNK at 6.5 in April 2003. Using the chart and your technical analysis skills you set your exit target at 11.3. We also set this price as the target in our sample portfolios, so you can verify your ideas with ours. In the middle of January 2004 ELNK reached your exit target and your position was closed out for a nice $4.80 per share profit or 74% gain over 8 months. Not bad.
There are two problems with using resistance as your target exit price. First, if the stock is reaching all time highs, then there will not be any resistance levels to use. As a result you will have to use another way to set your target. Second, resistance levels are also points of entry for many technicians if there is strong buying volume associated with the penetration of the resistance area. These breakouts can cause the price to continue its upward movement. When analyzing whether to keep your exit target, it is a good idea to monitor the volume the stock is experiencing as it reaches resistance. If the volume is strong, indicating good demand for the company’s stock, then you may want to move your exit target up to another level. Examine the chart of ENLK again, noting that the volume started to increase as the price neared resistance. Then it pulled back as it hit 11.3. This indicated that there was insufficient buying demand to push the price through this resistance level. Generally, I look for volume building and substantially greater (130% or more) than the 50 day moving average for volume as an indicator that the price has the strength to penetrate resistance. Otherwise it wise to sell at your target. You can also sell part of your position 1/2 or 3/4 to capture some profits and then let your trailing stop protect the rest of your profits.
Historical Point Move
Another way to set an exit target is to calculate the point move a stock has made over a recent time period, say the last year, and then use that number to calculate your target. Let’s say you are interested in Company ABC as a value play that is currently selling at 20. This price was at 30 one year ago. This 10 point difference becomes the number you add to your purchase price to set your target exit price. Assuming you decided to buy at 20 then your target price would be 30 (20+10=30). Since the time frame used to determine the gain value (10) was one year, you should assume that this trade will take that long to realize its potential.
Using the historical point move strategy is actually similar to the technicians’ use of resistance levels. The point move over a set time period, say one year, does not necessarily mean the historical price is a resistance level. However, this historical price does act as a sell point when investors use this approach.
Another consideration, is when tax consequences from taking profits becomes important. Assume you have a gain and you are approaching the one year anniversary of when you purchased the stock. Currently, short term capital gains are taxed at your normal tax rate, while long term capital tax rates are 15%. If you are in a tax bracket higher than 15%, then it may benefit you to sell your stock after the one year anniversary. Your specific tax situation can also influence when you should sell. Please consult your tax advisor to help assess your current situation.
My Preference
For all of my trades I look at the results of the fundamental and the technical approaches. Knowing the value investors place on a company’s stock to determine potential the potential sell price provides a disciplined process assess your own position. Using technical resistance as shown on the charts also provides a good indicator of what traders are considering as their sell targets. Blending of these two techniques provides the best way to create a target exit with confidence.
Hans Wagner
http://www.tradingonlinemarkets.com
An education and portfolio management site for investing and trading stocks. Our portfolios substantially beat the major indicies and include buy and sell suggestions.
