Taking Profits

Buying a stock is only half of your journey to building your wealth. Knowing when to sell is just as important. The first part of this course discusses why it's critical to cut your losses early. The second and third lessons teach you how to spot the best time to sell and take your profits.

These lessons are based on decades of research into the primary factors that move stocks. These principles aren't based on someone's opinion or theories from business schools. They're all based on what actually works in the market.

Lesson 2. Taking Profits

2.1 - When To Sell Stocks To Take Profits

How do you tell if a stock is at the end of a major price advance? In this lesson, you'll learn about ways to recognize when a stock starts sputtering and lock in your profits. Chart-reading skills are a key part of this education.

When To Take A Profit

Let's say you bought a stock and you're watching it go up. At what point do you call it a day and take your profits?

The sell signals discussed here and in other lessons can occur well before a stock has peaked. So it's important to learn to recognize critical sell signals. If you regularly review the characteristics of stocks that took a turn for the worse, over time you'll be able to quickly spot valid signals as soon as they occur.

There are several simple selling strategies that have proven beneficial in helping you consistently lock in profits.

Here's a simple one. Generally, stocks tend to move up roughly 25% to 30% after rising out of a base. Then they may go through a period of consolidation, when a stock seems to go nowhere for a number of weeks.

A strategy that safeguards your profits is to sell after you've captured a 25% gain. This is the conservative approach to profit-taking that works like "building blocks." Once you sell and take a 30% gain, compounding it with other 25% profits taken during the year should net you very substantial gains overall. This gets back to one of the basic tenets of investing: The key to being really successful is to capitalize on your strongest stocks.

The 25% profits will also outweigh any mistakes you make in stocks that start to take a nosedive if you also cut losses at 8% (see Lesson 1, "When To Sell Stocks To Cut Losses.") These two strategies alone could help you become quite successful in the market.

There's an exception to this rule, however. If a stock races up 20% in one to three weeks out of a proper base, it probably means it has plenty of fuel left and you should hang on to it. It may be your best stock. And always review the market conditions. In a strong market, you will see this situation often.

The shorter the trip to the 25% level, the stronger the stock.

2.2 - How To Read Sell Indications From Stock Charts

Often, the most important sell indicator is the stock's price and volume action as shown on a chart. Many times, stocks break down their upward trends before any negative signs emerge from fundamentals, such as earnings, sales, profit margins or return on equity. The following indicators can flag weakness in a stock and can be observed with the aid of Charts.

Volume Clues
If a stock's price falls persistently on heavy volume, it usually signals a shift in professional investor sentiment in which sellers predominate, making any price advances more difficult. Another red flag is a stock making new price highs on lower or poor volume.

Price Clues
The number of consecutive down days in price vs. up days will likely change and increase once a stock begins falling from its top. For example, a stock will close lower five days, followed by two days closing higher, compared to an earlier pattern of five days up and then two down.

Churning
After a substantial advance, the stock's trading volume increases but its price doesn't move up much for several days. This is called churning, or heavy volume without further price progress.

2.3 - Relative Strength

Sometimes sales numbers mask problems at companies. Companies may rely on just a handful of customers, and losing any of them may mean big trouble. Other companies are overly reliant on overseas markets, putting them at risk of bad economies or political strife abroad. Also, fluctuations in foreign-exchange rates can seriously dilute sales figures. Some companies, such as pharmaceuticals, get the bulk of their sales from a few flagship products. If sales in these items falter, it could mean more trouble than if the overall sales drop. With retailers, additions of new stores increase the sales figures, even if sales at existing stores slow down. That's why retailers report total sales as well as same-store sales, to provide an apples-to-apples comparison. Another pitfall happens when companies include sales that haven't actually taken place. Orders that won't be shipped or paid until weeks or months later sometimes are added to the sales total to inflate results. Also many a times the sales increase because of the price inflation and not actual demand, typical in commodity companies. Therefore price increase should be sustainable and not just a one time temporary phenomena.

Moving Average Lines

Pay close attention if the stock's price closes below the 50-day moving average. The 50-day moving average is generally regarded as a stock's possible price "support" level. It may not mean much when a stock dips below this level, but when it closes several weeks below the 50-day line, unable to rally, it suggests investors are abandoning the stock. Also worrisome is a 200-day line that turns down.

2.4 - Weak Breakouts

The stock breaks out of a basing chart pattern, but weekly volume is less than the week before, or volume is less than 50% above the stock's average over the past 50-days (The average volume is illustrated by the line moving across the volume bars.) This indicates lukewarm interest at a pivotal point for the stock, and it could later become a failed breakout.

Climax Tops
The stock, after a strong run-up for several months, reaches a "climax top" in which the price suddenly goes up even faster - 25% to 50% or more on heavy volume in a couple of weeks. The price spread for the week will be greater than on any prior week since the beginning of the stock's major move. Sometimes this run will culminate with the stock's largest single-day advance since it began moving up. As the name implies, this is a situation when a buying spree in a stock becomes too obvious and everyone is excited by the price action. When it's obvious and exciting, it's too late - sell into the euphoria.

2.5 - Exhaustion Gaps

Some climax runs will end with an "exhaustion gap," which happens when a stock that has been advancing rapidly and is greatly extended from its base opens at a price above the prior day's highest level. This usually indicates the final stage of its move - one final burst of buying before a stock eases back. However, when this happens close to the breakout, it is called a breakaway gain, and it can actually be a sign of strength.

Late-Stage Bases
As a stock advances, it builds several bases. The third or fourth base, however, is more prone to a decline. This is common among leading stocks. During the first base, the stock demonstrates inherent strength, but few investors notice it. When the second base forms, more investors notice it. By the time the third or fourth base forms, however, almost everybody notices it, including most of analysts, brokers as well as dealers. That, oddly enough, is historically the time when the stock is most likely to sputter.

2.6 - Learn To Interpret The Market

One of the most important selling rules applies not to individual stocks, but to the market as a whole. You may be right about your stocks, but if you're wrong in your assessment of the general market, your stocks will suffer. During a market decline, even good stocks have a hard time swimming against the market's current. Typically, three out of four stocks go down in a declining market.

The market always begins a downturn with a series of distribution days in which selling predominates. Over the course of a few weeks, at least one of the major market indexes (the Sensex or the Nifty) closes lower or stalls several times on higher trading volume than the prior day. This is another example of churning, and every major market downturn has begun with one such episode.

Also during weakening markets, the leading stocks (those that have led the market's uptrend) typically start to falter.

When the market enters a confirmed downturn after four or five days of clear distribution in a market index, you're better off selling some of your stocks and raising some cash. Get off margin (that's when you borrow from your broker to buy stocks) at once. Sell your worst performing stocks first. Of course, you'll need to keep watching the major market averages to identify the market's next turn. You may see the market rally for a few days, only to falter.

Learn to recognize a valid market upturn so you aren't misled. Always regard the 8% Sell Rule (selling any stock that falls 8% below your purchase price) as your safety net, particularly in market declines. Track signs of weakness in both your stocks as well as the general market.

Next: Selling Indicators