It’s important to know when to buy, but if you’re going to get into the stock market, it may be more important to know when to sell
While buying right is important, in the type of market we now have I think learning good selling rules and using them is perhaps more important. In fact, often selling can save us from a wrong buying decision. For example, investors who bought shares in Enron, Nortel, Sask Wheat Pool and even Bombardier some years ago suffered huge losses. But selling right would have saved those investors big bucks, preserved their portfolios and prevented a lot of mental grief.
Here’s the background: From August 1982 until early 2000, North America was enjoying a bull market. Stocks were volatile, seasonality was likely an issue for some investors and there was no high frequency trading. Many investors bought on dips or when they had new money and held onto stocks for years. It worked and, in most cases, worked well.
For one thing, high frequency trading can move stocks and indexes rapidly and often, with very little real news. These days many stocks are more volatile than they used to be, although the volatility index is quite tame.
Seasonality has made its way into books, newsletters and the news — and the minds of many investors. Investors have documented why stocks move when they do and more and more investors are learning how to get in step with those seasonal moves.
There is a lot of bad news going on in the world, but then there always was. I’m not so sure the bad news on its own causes volatility, but combine it with high frequency trading and hair triggers on the sell button and stocks can drop a lot faster than they go up.
If you learn selling rules you can use them to help you sell your farm commodities. All you have to do is believe the sell signals. That usually takes some practice, and giving back some profit.
Investors using technical analysis lean towards being more active, so let’s look at some selling rules or guidelines.
In my case, while I like capital gain, I don’t count on it with most of my stocks. So I like to sell covered calls and do spreads. Premiums are bigger for calls and puts on volatile stocks, but volatile stocks can also eat up equity and beat up an investor’s mind. I need selling rules. Maybe you do too, so here they are.
Two selling rules
In his book How to Make Money in Stocks, author William J. O’Neil outlines two selling rules.
Rule one is sell if a stock drops eight per cent from the purchase price. Jesse Livermore and Rothschild would sell when stocks dropped three per cent. Livermore would also sell if the stock or commodity did not perform the way he expected it to, even if it was an hour after he bought.
If you sell when a stock is down eight per cent, you only have to make 10 per cent to get back to breakeven. That’s quite easy to do. Plus, dropping 10 per cent likely won’t upset an investor’s mind or spouse very much. If you sell when you’re down 50 per cent, you have to double your money to get back to breakeven, and that’s not so easy to do. Plus, generally, such a big loss will discourage an investor (or his or her spouse) and give the stock market a bad name.
O’Neil’s second rule is sell if a winner drops 12 to 15 per cent from its top — unless of course rule one applies.
1. Sell when a stock stops going up.
2. Sell when you’re up a pre-decided amount, like 15 per cent. Some will say that if you follow this rule you’ll never feel the thrill of doubling your money on a stock. Suit yourself. But think on it: if you made 15 per cent on our money in the first three months of the year you could take the rest of the year off and likely beat the market.
3. Sell when the Moving Average Convergence-Divergence (MACD) and Full Stochastic indicators flatten on top and start to roll over. Unfortunately the MACD is a lagging indicator and too slow to be a good selling indicator in a volatile market. The Full Stochastic will give a sell signal much sooner so I like to use it as part of my selling strategy.
4. Sell when the price drops through a trend line. If you set up “price performance” on your chart, when the price performance chart stops going up, that’s a sell signal. The general rule is that as long as that chart is moving up, hold the shares. When or if the daily price drops the price performance will start to roll over and it will be time to think selling.
5. Use a buy/ sell service and follow it. One service I’ve heard about lately is called Parabolic. I will be looking at it one of these days and will write about it another time.
6. Some investors sell when they find a better stock. That was okay in the bull market from 1982 on but these days I don’t think I would follow that selling rule. There are many good stocks and after they drop in price they become even better stocks if we have money to buy them.
My favorite sell signal: In March 2012 I started to seriously track selling when the daily price of a commodity or my shares dropped through the 10-day moving average (dma). I have to admit I have not followed it perfectly and I won’t say that was part of the research. Many fear being whipsawed if they sell at such a tight sell signal and that could happen. However my counter argument is that if you sell early and you’re wrong, at least you get the most of your money. If you don’t sell early and you are wrong you risk losing a lot more money or giving up a lot more profit. Some prefer to sell when a stock drops to the 20 dma — that should reduce the odds of being whipsawed so suit yourself.
But this business of losing 50 per cent on a stock is something we should all avoid. It gives stocks a bad name, it can discourage us and it is very difficult to rebuild the portfolio. I know that when I lose big bucks on a stock I am not very proud of myself, or the business of stocks. I don’t get discouraged easily but some investors do. Losing money also gives the stock market a bad name. If we’re dealing with stocks we really are working a business. We should take losing money seriously just like we would in any other business.
When I sell out and I’m right, I like the strategy and the stock market. If I sell out and I’m wrong I can always buy the stock back or buy another one. But in the meantime I have the money.
Taxes are certainly a factor and beyond the scope of this presentation. However, we are in the business of making money, and taxes are something we have to deal with. These days we have RRSPs and Tax Free Saving Accounts that can help us deal with tax issues.
We have a nice group of members in our Technical Analyst Group in Winnipeg. We meet the first Wednesday evening of each month. There is a similar group in Calgary too. If you join the association, you will be sent notices about many webinars that you can tune into. If you want to go to a meeting, email me for details. Remember, the cost of belonging to these technical groups is tax deductible just like the cost of belonging to a farm organization or an employees’ union.
Recent investing activity
I have been selling calls on quite a few stocks. I bought West Jet (WJA) shares and sold a call below my cost and picked up an easy $500 or so in a couple of weeks. The share prices went up, so I bought the call back, sold the shares and kept the $500.
My Bombardier shares are touching $5 as I write on September 9. The company’s new plane, the C series, is scheduled to have a test flight any day now. I expect shares will go up half a buck or so when the plane flies. Bombardier is paying a 2.5 per cent dividend while I wait for the plane to fly. I have a lot of shares of Bombardier at an average cost of about $4.58 per share.
I sold calls on quite a few shares of First Majestic and IMG gold. Too many to count at this time.
I continue to do spreads on a short list of stocks. Since we are in the period of “Sell in May and go away,” most of my spreads are called bear call spreads, where I buy a call on a stock with a low premium and sell a call on a share of the same company and same month but with a higher premium. I keep the difference, unless the share price comes up to my strike prices.
I think doing spreads is the final skill I needed to learn about how to use options to bring in cash. The sequence goes something like this: Buy shares for dividends and capital gain. Buy shares to sell calls on to collect cash. Do not buy shares but do spreads is likely the third part of my option strategy. You don’t own the shares to do this, but you do need to have buying power in your trading account and be approved by the broker to do spreads.
My standout stock for doing spreads has been Green Mountain (GMCR). This stock has weekly options which come and go very quickly, As of Friday, September 6, I had brought in something like $2,100 with that stock and I don’t even own any shares. On this stock it has been quite easy or me to pick up $200 to $400 or so per weekly spread. You can do the math, even if I don’t win 100 per cent of the time.
Other stocks I do spreads on include Home Depot, Deere, Cat, Toyota, PotashCorp and Agrium. Potash bit me twice. The first time was my own oversight. The second time was when Russia’s potash miners ended the cartel and Potash shares dropped $10 overnight. But as of September 6, that account was within $1,500 of making enough money to offset those losses. I think that is quite an accomplishment.
By doing some weekly spreads, I might have anywhere from four to eight weekly spreads per month plus five or six monthly spreads, which means I do 10 to 14 spreads a month. If I can make just a few hundred dollars per spread, it can add up to a lot of money in a year — as long as I don’t give the profits back through careless losses. Since this is in a trading account the profit would be taxed as capital gain. I teach all this stuff in my newsletter StocksTalk.
On a personal note, I painted my 1979 Datsun the other day. The usual — half a litre of fire engine red Tremclad, a buck’s worth of masking tape and about three hours of work with a three-inch short hair roller. Looks great at 50 feet. Actually, looks good close up too. †