Tuesday, August 15th, 2006
The only profit-taking rule you’ll need (part I)
Our recent article on creating a modified CANSLIM system got an interesting response from one reader:
“I don’t need to know when to buy. I need to know when to sell.”
The reader is right: it is often harder knowing when to sell to take profits than when to buy. Like most things, the key to solving the ‘when to sell’ problem is to keep it simple.
For CANSLIM and breakout traders who hold stocks for weeks or months there is really only one sell rule you need.
It is based on a simple trailing stop loss and is not hard to use. While reasonably well known, amidst the plethora of advice, market action and technical signals it is easy to forget.
Until it was explained clearly by Colin Nicholson, we too were grappling with when to take profits. Mostly because we were bamboozled by dozens of possible sell rules.
(Article continues)
In How To Make Money In Stocks: A Winning System in Good Times or Bad, 3rd Edition, William O’Neil outlines the following rules for taking profits:
1. Climax tops: including exhaustion gaps, stock splits, signs of distribution, hitting upper channel line, price 70 per cent to 100 per cent above 200-day moving average
2. Low volume and other weak action: new highs on low volume, signs of poor rally, poor relative strength
3. Other prime selling pointers: Take a few profits when stock’s up 25 per cent, sell on good news, sell when it’s obvious the stock is going higher
We can guarantee that with such a huge number of rules for taking profits you could find an excuse to sell holdings almost every day.
One of the hardest aspects of trading is to let your profits run and avoid the temptation to take them prematurely. The only way around that is to have a clear, simple rule to sell and lock in profits.
That sell rule is based on Dow Theory, which provides us with a simple definition of a trend: a stock trending up is making higher peaks and higher troughs, as shown in the chart below.
To lock in profits, we just have to sell when the stock is no longer trending.
Let’s look at the diagram below to see how to implement it.
Starting at the bottom left we buy when the stock hits a new high after a period of sideways price action (also called a trough, base, consolidation pattern, or congestion). The base is an area of support where buyers have been accumulating the shares, so we put a stop loss below it at No.1 (we’ll deal with where exactly later on).
The stock moves higher but then reacts again and forms another base. This is a period of uncertainty because we have had profits but they start to melt away in the reaction. But our goal is to get big profits and we want to give the stock room to move, so for the moment we leave the stop loss at No.1
We only move the stop loss up to No.2 when it hits another new high. As shown in the diagram we keep doing this until we have stop loss at No.4. We’ve locked in some healthy profits by letting the stock trend up.
While the stop loss is at No.4 the stock makes a new high. But this time, instead of making a higher base (trough), it falls below the previous base. It is no longer making higher bases. This is a violation of our definition of a trend and our stop loss is triggered. So we get out!
The benefit of this method is that there is ONE rule to locking profits.
These are questions you’re most likely thinking already:
Don’t you give back lots of profits when you’re sold out?
Yes, but that is the price you pay for letting profits run.
How far below the base do we put the stop loss?
It all depends on the stock’s volatility but we’ve found that between 1 to 2 per cent works best. One of the most important things is to put it below a round number. So if if the logical place for a stop loss is $1.55, put the stop loss at $1.49 instead.
Won’t market makers shake me out and run my stops?
We haven’t found that to be the case if you follow the two points above.
How do I tell what a base is?
That will require some hard work and trial and error. But basically the base should be significant. That is, when you eyeball the chart it should look like a valid correction. Tomorrow we’ll look at some examples to help you get an idea of what to look for.
Word Count: 757. This entry was posted on Tuesday, August 15th, 2006 at 8:38 pm and is filed under When to sell. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.
May 1st, 2009 at 1:47 am
[...] calls for me to move stops up after the price moves above each defendable position (as explained in The Only Profit-Taking Rule You’ll Need). But sometimes it’s not clear [...]