Lesson 1. Cutting Losses
Selling Stocks To Cut 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 selling strategy can help you avoid heavy losses and
preserve your portfolio. This lesson explains how to sell when a stock selection
doesn't pan out.
Know When To Fold 'Em
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
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 shield 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.
It's not just your own personal opinions that can be wrong. Analysts or market commentators
can be just as erroneous, and basing your decisions on their opinions can often
lead to disastrous results. Investors often buy loser stocks, justifying their decision
with remarks like, "All these Wall Street analysts are saying great things about
this company," or "This technology is the greatest thing since sliced bread. The
market doesn't realize it yet, but it's bound to become a household item." Famous
Cut Your Losses Early
The first rule is sell any stock that falls 8% below your purchase price. Why 8%?
Because research shows stocks showing all the right fundamental and technical factors
in place and bought at precisely the proper buy point (which is explained fully
in "Lesson on Charts") rarely will retreat 8%. If they do, there's something wrong
You may think a stock is due to rebound. But the market could send the stock to
lower depths regardless of your views or what analysts and commentators say on TV.
No excuses, no alibis. 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 don't and
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 $80. To get back to Rs.100, the stock has to make a 25%
gain. Another example: The stock plummets 50%, to Rs.50 a share. It would take a
100% jump 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 plunge 8% immediately. Buying exactly
right will solve half your selling questions.
How Cutting Losses Helps You
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? It would take several 8% losses to wipe out the profit from just
one or two good stocks.
The 8% Rule Applies Only To Losses From The Purchase Price
The 8% Stop Loss Rules Applies Only To Losses From The 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 as it came
out of a sound basing area at the right buy point. (For more on this, check lessons
on charts ) 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 And Other Considerations
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.
Also, tax considerations and brokers' commissions should rarely enter into your
sell decisions. You shouldn't always hold a stock for more than a year just because
you'd pay a lower tax rate on the profit. And with lower commissions today, they
should not be the most important factor. Your main goal should be to obtain and
nail down gains.
Holding Losers In Your Portfolio?
You may be looking at your portfolio and seeing there's some stocks 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 can
not 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
Lesson 2. Taking Profits
- The first sell rule is to get rid of any stock that falls 8% below your purchase
- 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 (as determined
by the stock's chart pattern). 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 commission rates.
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.
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.
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.
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.
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
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.
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.
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.
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
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
Lesson 3. Selling Indicators
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
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
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
- Too many stock splits close together in time can push a stock lower.