When it comes to selling, you have 2 choices

The market extended its recent consolidation today as is wiggled back and forth and finished slightly positive. The S&P 500 has now closed between 1249 and 1269 for 15 days in a row. Today’s quiet action is no surprise ahead of the Fed meeting tomorrow. The reaction to the Fed’s statement could easily provide the catalyst to break us out of this trading range (in either direction). The trading bias here remains long but that could change quickly should current support levels give way (1249 S&P 500, 2230 Nasdaq).

Last week I discussed protective stops as the first in a series of “when to sell” columns. Today we will look at part one of profit taking.

Deciding when to sell and take profits is normally the most difficult decision that traders face. It is also the decision that is most often second guessed. Should I have held on? Should I have sold sooner? Should I have scaled out? Compared to selling, buying is easy. For any trader that uses technical analysis, buys are made when a pre-defined trigger point is hit. “If this happens…buy.” Rarely do I hear traders second guess their buy points. This is because whether a trader looks to enter on a breakout, a pullback, a crossover, or some kind of oscillator signal, the rules are normally well defined. To take the second guessing (and subsequent mental anguish) out of profit taking, traders need to have sell rules as well as buy rules. The key is to structure your sell rules in a way that you can comfortably follow them. If you can’t comfortably follow them, you’ll end up breaking the rules and second guessing yourself anyway.

The first thing to understand when determining your profit taking rules is that you are never going to sell at the top. There is no method that will consistently allow you to get out at the very top of a move. That’s reality. There are two ways to deal with it:

1) You can sell too early
2) You can sell too late

These are your only choices. Today I will talk about the pros and cons of each. Next week I will expand on this theme and discuss how it is possible to mix methods to achieve your ultimate comfort level.

Selling too early

Traders whose sell disciplines call for them to sell too early never wait for a confirmation that a top has been made. Instead they look to take profits either when certain targets are hit or the trend’s momentum begins waning. Here are some things to consider when using a “sell too early” discipline:

Pros
1) When selling too early it is much easier to get a good fill. This is especially true for larger positions. Unloading stock is a lot easier when the price is moving up than when it is moving down.
2) By selling too early, your account will be less subject to large drawdowns. You’re not waiting for the top to confirm itself and therefore won’t have to suffer through watching a position that was once a big winner reverse and stop you out for a small gain or loss.
3) Your capital will be hung up for shorter periods of time. By taking your profits earlier rather than later you can put that capital back to work in your next trade.
Cons
1) You are significantly reducing the chances of a “home run” trade. If after you sell the security continues to move in your direction, you will miss out on that part of the move. This can be especially notable on big moves.
2) You will be more prone to shakeouts. A “sell too early” mentality frequently means using profit targets and tight stops. The tighter the stop, the more likely you will be shaken out of a move before its completion.

I know of many successful short-term traders that use the “sell too early”. Their methods call for them to take profits as certain targets are reached, and continue to scale out as the position moves in their favor. While entry signals can catch major market swings as well as minor market swings, the “sell too early” discipline doesn’t permit waiting around to see if the swing will be major or minor. Rather they will take what the trade gives them over a short time period and then move on to the next trade – happy to have a decent gain.

Selling too late

Traders whose sell disciplines call for them to sell to late are looking to make sure that that they ride the trend for all it is worth. They don’t want to see their position go on to huge gains without them and will do what is necessary to ensure that the move is over before they exit their position. This is most commonly achieved through the use of trailing stop techniques. Here are a few pros & cons to consider about selling too late.

Pros
1) “Home run” potential. It’s impossible to know how long a trend will last. Some trends can last a long time and allow an investor to realize incredible gains. Traders who decide to adhere to the “sell too late” discipline have a chance to make huge profits on any trade.
2) Less prone to shakeouts. By using looser stops you will be less affected by all the noise and more likely to be able to hold a position throughout its move.
Cons
1) Subject to larger drawdowns. Sometimes a stock can fall pretty far before a top can be confirmed and the previous trend declared dead.
2) Capital is hung up for longer periods in each trade. Sometimes it can take a very long time before it can be determined that a position has topped out. During this period of time, you would normally be better served to have your money invested elsewhere (or in cash).
3) Sometimes difficult to get a good fill. If your stop happens to be placed near the stops of a lot of other people your chance of getting a good fill are significantly reduced. This is especially true for large positions or thinly traded stocks. Due to this, your trades will have higher slippage costs.

“Sell too late” is popular with intermediate-term traders. They will never sell at the top, but will capture a large portion of the move and will realize fantastic gains on some trades.

There is no right or wrong here. You can sell on the way up, or you can sell on the way back down. You can make money either way. What’s difficult (near impossible) to do is consistently make money by arbitrarily selling without a discipline in place. I’ll expand on these thoughts and discuss some of my preferences for taking profits shortly in my next “when to sell” column.

Until Wednesday…good trading,

Rob Hanna
RobHanna@Comcast.net

For those who may be looking to expand their knowledge beyond just market timing, my Hanna ETF Money Flow System utilizes the VIX in generating trading signals for spread trades.

Rob Hanna is the principal of a money management firm located in Massachusetts. He has spent the last several years developing and refining methods for trading in stocks across multiple time frames. He selects stocks using both fundamental and technical criteria, and then trades them using technical analysis techniques.