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Lessons On Selling Stocks

lessons on selling stocks
How to Sell Stocks to Maximize your 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 1. Cutting Losses

Selling Stocks to Cut Losses

Success in the stock market is as much about limiting losses as it is about riding winning stocks. A rule-based and disciplined selling strategy can help you avoid heavy losses and preserve your portfolio value. This lesson explains how to sell when a stock does not perform as per your expectations.

You can’t be right all the time

Nobody's right all the time in the market, not even veteran market professionals. But as the famous investor Bernard Baruch once said, "Even being right three or four times out of 10 should yield a person a fortune if they have the sense to cut losses quickly."

If your stock selection doesn't work out and you're faced with a loss, sell to limit your losses; act quickly.

Being a successful investor is just as much about limiting losses as it is about riding a winning stock. Downturns are a part of life in the market, and you must act decisively to protect yourself from excessive losses. If your stock selection doesn't work out and you're faced with a loss, don't let your pride stop you from admitting you've made a mistake and acting quickly. Cut your losses early and move on. You must make rational decisions instead of trying to rationalize your way out of a costly mistake.

Cut your losses early

The first rule is - sell any stock that falls 8% below your purchase price. Why 8%? Because research confirms that stocks with all the right fundamental and technical factors and bought at the proper buy point rarely will fall by 8%. If they do, there's something wrong with them.

Sell the stock if it falls 8% below your purchase price. For example
Your purchase price per share Rs. 100
The stock price falls to Rs. 92 or lower [8% fall from your purchase price of Rs. 100]
Your decision should be SELL
Make no exceptions to the rule.

You may think a stock will rebound. But the market could send the stock to lower levels regardless of your views or what commentators say on TV. You may want to sell even before an 8% loss if you see other signs of weakness in a stock.

This rule emphasizes the importance of buying at the right time. If you buy a stock that is overextended (that's reaching the end of its climb), chances are it will hit the 8% sell level as it goes through a normal pullback. Make no exceptions to the rule. The best stocks will always give you other opportunities to buy. Here's another way to look at it: Once a stock falls 8% below your cost, does it still look attractive? Is it still among the best stocks? Probably not. There's no guarantee that it will go back up, and you need to protect yourself.

The bigger the fall, the harder it is to recover. Say you bought a stock at Rs.100 a share. It falls 20%, to Rs. 80. To get back to Rs.100, the stock has to make a 25% gain. Another example: The stock falls 50%, to Rs.50 a share. It would need to rise by 100% to get it back to Rs.100 — and how often do you buy a stock that doubles? And if it does, how many weeks, months or even years does it take to get there? Wouldn't you rather cut your loss early and free up money to purchase another stock with better chances of doubling?

Of course, it could happen that you sell a stock that falls 8% and then watch it go up afterward. But you have to think of the 8% sell rule as your insurance policy against catastrophic losses. The rule will in effect limit any losses on your portfolio to no worse than 8%.

Nevertheless, if you've bought a fundamentally sound stock at the right point, (explained in the stock buying lessons) it will rarely fall 8% immediately. Buying exactly right will solve half your selling questions.

How cutting losses helps you

Here is an example to show you how cutting your losses can be beneficial:

Stock Shares Cost/Share Sell Price Profit/Loss %Profit/Loss
A 100 Rs.50 Rs.46 -Rs.400 -8%
B 100 Rs.50 Rs.46 -Rs.400 -8%
C 100 Rs.50 Rs.60 Rs.1,000 +20%
D 100 Rs.50 Rs.46 -Rs.400 -8%
E 100 Rs.50 Rs.46 -Rs.400 -8%
F 100 Rs.50 Rs.46 -Rs.400 -8%
G 100 Rs.50 Rs.75 Rs.2,500 +50%
  Total     Rs.1,500  

As you can see, even if you had made these seven trades over a period of time — and taken losses on five of them — you would still come out ahead by Rs. 1,500. That's because the two stocks that worked out resulted in a combined profit of Rs. 3,500. And the five losses — all capped at 8% — added up to Rs. 2,000.

You see the point? Even several 8% losses may not wipe out the profit from just one or two good stocks.

The 8% Stop Loss applies to your Purchase Price

The 8% sell rule, however, applies only to drops below your purchase price and does not apply to situations where you've already made gains on a stock.

Dealing with Hyperactive Stocks

About 40% of stocks pull back close to their buy point for one or two days. This is not the time to panic and sell, especially if the stock was purchased at the right buy point. As long as the price doesn't drop 8% below the point at which you bought, you should, in most cases, hang on through the first pullback.

Watch how the stock performs relative to the general market and its industry group peers. Often, a stock pulls back close to the buy point for one or two days because the general market has temporarily pulled back. This is normal. On the other hand, if the market has been rallying over several days and your stock hasn't come to life, then this might be a warning sign, even if the stock hasn't dropped 8% below your purchase price.

Stop-Loss Orders

“Sell if the stock falls to 8% below my purchase price,” Anand tells his stock broker – example of a stop loss order.

Some investors like to use stop-loss orders, which are instructions to brokers to sell a stock at a predetermined price. This might be useful for those who can't watch their stocks closely or for those of us who may be less decisive.

Tax and trade expenses

Tax considerations and brokerage charges should not be given importance in your sell decisions. You shouldn't always hold a stock for more than a year just to avoid paying tax on the profit. And with lower brokerage charges today, they should not be the most important factor. Your main goal should be to make and retain profits.

Holding Losers in your Portfolio?

You may notice that your portfolio includes some stocks that are already 8% below your purchase price — or worse. Should you sell them? Probably yes because as the stock goes lower, it becomes even more difficult to sell. It is easier to sell a stock which is down 8% to a stock which is down 30%. You feel that the stock cannot go lower but feeling has no significance in the stock market. There is no guarantee it will rebound and the chances are it could go even lower. The greater the loss, the greater the chance of it developing into a really serious loss.

Key Points to Remember

  • The first ‘sell’ rule is to get rid of any stock that falls 8% below your purchase price.
  • It's critical to follow this loss-cutting rule regardless of how highly you value a stock. Personal opinions get in the way of smart selling decisions.
  • The larger the loss, the higher the recovery you need to get back to the break-even level. (A 50% loss requires a 100% gain to break even.)
  • Strong stocks sometimes initially retreat close to their buy point. This doesn't necessarily mean you have to sell, unless the stock goes 8% below the purchase price.
  • Avoid making ‘sell’ decisions based on tax concerns or brokerage charges.


Lesson 2. Taking Profits

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.

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.

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.

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.

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.

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.

But we have already done the hard work for you. Market Direction is presented in the Market Analysis section.To avoid serious damage take the pain to read the 'Market Direction' daily.



Lesson 3. Selling Indicators

Reading Key Selling Indicators

Just like stocks flash signals before making huge gains, they can also show certain characteristics that indicate potential trouble. In this lesson, you'll learn to identify the warning signs of a weakening stock.

Sell Signals Aren't Always Obvious

If sales growth starts to slow, does it really mean trouble for a company?

If the leading stock in an industry group sputters, does it spell a similar fate for other stocks in the group?

And must you always sell if earnings are disappointing?

For investors, these questions are just as challenging as finding the right stocks to buy. Sometimes, stocks can fool you. They peak on seemingly the best days, when financial magazines rave about them, and shareholders are bubbling with excitement.

But some of the same tools that indicate the potential for a stock to go up, can also tell you if a stock is headed down. This lesson will help you isolate the most useful fundamental indicators. But keep in mind that a stock's price and volume action is also valuable in spotting sell signs. Many times, a stock's chart will reveal something wrong with a stock much earlier than fundamental factors.

Finding Flaws In Company Fundamentals

If you want clues to a stock's decline, you can basically take all the financial indicators that drive a stock up — such as earnings growth, sales growth and profit margins — and turn them upside down. These are your red flags:

A sharp slowdown in earnings growth in back-to-back quarters. For example, if a company's earnings growth has been in the 100% range for several quarters, it's bad news when that slows down to 20% or 30%. The street has little patience and will quickly turn its attention to other, faster-growing companies. You should also pay attention to companies whose earnings or sales growth break a habitual pattern. For example, if a company had earnings growth over several quarters between 25% and 35% then reports three quarters of steady deceleration, this could be a red flag. Such subtle slowdowns in earnings or sales can sometimes lead to the company eventually missing earnings forecasts.

Significant drops in other main fundamentals — sales growth, profit margins and return on equity — should serve as warning signs, especially if the stock starts having trouble making gains. Check the Sales+Profit Margins+ROE Rating for any significant drops in this gauge.

Industry Groups Tend To Move Together

When the majority of best-performing stocks in an industry fall sharply on heavy volume and are unable to recover, typically other stocks in the same industry could become vulnerable.

For example if ICICI Bank or State Bank of India is falling sharply on heavy volume, the fall of the other banking stocks could be on the cards.

Flagging Leadership Is Cause For Concern

One of the best ways to tell if a stock might go higher is by how it's performing already. When a stock no longer outperforms its peers, it's telling you the road will probably get bumpy. You can tell exactly how a stock is performing with the Relative Price Strength. Your stock should better than its pears.

Selling Clues From Institutional Investors

The buying activity by mutual funds and other institutional investors is a huge influence on stock prices. Just as it's wise to buy stocks funds are buying, you might in certain cases consider selling stocks the funds are selling. Professional selling can be witnessed on the charts when stocks fall on heavy volume. One can also see the institutional holding in the shareholding pattern published every quarter on the websites of BSE and NSE.

Stock Splits May Flood The Market

Stock splits are when a company increases its shares outstanding and the share price is adjusted accordingly. For example, XYZ Corp. sets a 2-for-1 split of 100 million shares trading at Rs.50 each. After a split, there are twice as many shares, or 200 million, trading at Rs.25. Companies do this to lower the share price in hopes of drawing more investors into the stock.

But too many splits can have the opposite effect. Adding shares can tilt the supply-demand equation because there's a bigger supply of shares to go around. The stock price could fall. Carefully watch any stock that has split more than once in the past 12 months. Consider selling if a stock runs up 25% to 50% for one or two weeks on a stock split. However, a few hyper-growth stocks have kept climbing despite more than one split a year.

Key Points To Remember

  • Consider selling a stock if it shows fundamental signs of weakness, such as a steady deceleration in earnings or sales.
  • Watch for weakness in the stock's industry group. When the leading stocks in an industry decline, the other stocks in the group may typically go down, too.
  • If there are signs that mutual funds are consistently selling the stock, you should consider selling.
  • Too many stock splits close together in time can push a stock lower.
 
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