How to exit trades is a subject worthy of a book, or several books, and not just a brief article. After all, there are stop-losses, trailing stops, profit-target stops, Fibonacci prices retracements and extensions, time targets, market orders, limit orders, stop orders, stop-limit orders, and so on. Each one of these can be the subject of their own article.
I'm going to address a particular exit, one I designed for exiting from stocks that have made sharp moves higher.
How many of you remember IOM (Iomega)? This was a stock that in the late 1990's was trading at over $100 a share but in 2000, had dipped to about $2 a share before being bought out by EMC. Assuming you bought it when it was $50, wouldn't you have preferred selling it near $100 rather than at $5?
Let's ask the question another way: How high is too high? Everyone enjoys the rush that accompanies owning a stock that gaps open higher every day and starts a parabolic run to new highs. But at what point does that little voice in the back of your head say, "It's too high, should I sell?" Here's an end-of-day trading technique that helps quantify the answer to that question. Not only can this technique be used as an exit strategy, aggressive traders may want to test its usefulness as a short entry technique.
Stocks that move too high off some mean price, whether a moving average, Bollinger Band, Standard Deviation line, etc., eventually revert back towards that mean. Think of a rubber band - the tighter it's stretched, the stronger the snap-back to the original state. I use moving averages as the mean against which I measure the stock price.
The Setup
The technique is a two-condition test. It begins by comparing the stock price against the 50-day Simple Moving Average (SMA) and the 200-day SMA. The setup condition is that the price (either close or intraday, depending upon the preference of the trader) must reach either:
A) 50% above the 50-day SMA; or
B) 100% above the 200-day SMA.
For example, if the 50-day SMA closed at 20 and the stock price reached 30, then setup condition A would be met. If the 200-day SMA closed at 15 and the stock price reached 30, then setup condition B also would be met.
Both extremes above the respective moving averages need not be met simultaneously to trigger the setup. Assume the 200-day SMA was 15, the 50-day SMA was 25, and the stock closes at 31. The closing price meets our setup condition because at least one of the SMA conditions (double the 200-day SMA, condition B) was met.
The Trigger
The second condition (the trigger) is what I call the Day of Weakness (D.O.W.). It is a confirmation that the stock has "peaked out." It applies only after the setup condition has been met and is any one of the following:
1) Gap open higher than yesterday's high, close lower than yesterday's low or close;
2) Gap open higher than yesterday's close, close lower than yesterday's low or close;
3) Gap open higher than yesterday's close, close at or near the low of the day but higher than yesterday's high or close;
4) Higher high than yesterday's high, lower close than yesterday's low or close;
5) Lower high than yesterday's close and a close at or near the low of the day;
6) Gap open lower than yesterday's low and a close at or near the low of the day; or
7) Gap open lower than yesterday's close and a print today lower than yesterday's low.
The trade is placed the following day. With all trigger conditions except trigger condition 5, a sell stop tomorrow is placed one tick below the first half-hour's trading range. With trigger condition 5, a sell stop tomorrow is place one tick below yesterday's low.
Let's examine two of the D.O.W. conditions in detail. For illustration purposes I refer to the setup day as "Yesterday" and the trigger day as "Today." In all the examples, the intraday price reached or was already 50% above the day day-SMA or 100% above the 200-day SMA.
Trigger # 1 - Gap open higher than yesterday's high, close lower than yesterday's low or close
Here's an example from just two weeks ago and with a low priced stock - HOV:
On 8/5/09, HOV hit a high of 4.34 and the 50-day SMA was 2.60. Setup condition A was met. The next day, 8/6, HOV gapped open higher (4.46) than yesterday's high (4.34) and closed lower (4.03) than yesterday's close (4.22). Exit tomorrow on a sell stop one tick below the first half-hour's trading range. You would have been stopped out in the morning. Assuming you were stopped out at the low of the day (4.11), you would have saved a bundle - HOV dropped an additional 13% to the low of 3.56 on 8/17.
What about three weeks later when HOV spiked up to $5.75? That D.O.W. came on 9/1, with simultaneous Triggers #4, #6 and #7.
Trigger #5 - Lower high than yesterday's close and a close at or near the low of the day
This rarely found trigger can be a powerful topping signal. Please look at the chart below of DSX:
On 10/29/07, DSX gapped open higher and closed at 44.82 with an intraday high of 45.15. The 50-day SMA was 29.91 so the high of the day was slightly more than 50% above the 50-day SMA. Setup condition A was met.
The next day, the high was lower than yesterday's close and it closed near the low of the day. With trigger #5 met, tomorrow place the sell stop one tick below today's low (38.54). That wasn't reached until 11/5/07. Assume your sell stop was placed a tick below the 10/30 low and you exited at 38.50. As you can see from the chart above, DSX fell to $20 in January 2008. Had you exited at 38.50, you would have avoided a 48% drop to the low. Had you shorted at 38.50, you would have made a 48% gain!
Of course, they don't all work out this nicely. There will be times where you get stopped out at the low and the stock almost immediately turns higher - not a problem if you've exited a trade but potentially a problem if you went short. In case of the latter, honor your buy stops and preserve your capital.
Dave Steckler is an investment advisor at Global Investment Solutions. In 2002 he developed the Alpha Rotation Program (ARP), a long-short market timing system using no-load mutual funds and exchange-traded funds (ETFs). He also trades a portfolio of stocks and ETFs.
