The Stock Surfer

Reader Question: Do I Have A Selling Problem?

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[Note: The following was posted on my personal blog, with charts].

Dr. Stock Surfer,

I've gradually come to see the light on Trading Rule #1: No big loser. The 8% rule (or 5%, whatever one's tolerance) has stopped me out of more positions that turned out to recover soon than those that plummeted, but I haven't had any more 20+% loses (See AXP, AIG). However, what about losses on stocks that have done well? Exhibit A: I bought JRCC early in 2007, and was thrilled to watch it go up 120% in about 4 months. However, I then watched it slide over the next few months and ended up exiting with something like a 60% gain. (We've dated many times since then, and though most dates have had happy endings, I tired of the volatility and decided to "move on" this spring.) I've since placed stops - or partial stops - on some other winners with mixed results.

This seems to be somewhat a psychological question: While I won't tolerate a 8% loss from scratch, I seem to willing to overlook a 20% drop if the stock has already appreciated 80%, when the only real difference in the two positions is that I happened to purchase stock B at a more opportune time. What's the Rx? Do you use the 8% loss rule on winners?

Signed,
Investing student with a selling problem

Dear Investor,

You pose an important question that has no easy answer. Indeed, there may be no "correct" answer. Some people make money using a buy and hold strategy, others make money day trading--in each case their rules for selling match their time horizon and tolerance for pain. I will try to lay out my own selling philosophy, which I don't always stick to but I try to.

PHILOSOPHICAL REASON FOR SELLING DISCIPLINE?

The most compelling reason I have for my own selling discipline (i.e. using rules) is that I recognize my own ignorance, skepticism, and limited resources. I am not a financial analyst and cannot determine the "fair value" of a company. Furthermore, I am skeptical of those who are financial analysts and think they can determine what a stock price should be. Exhibit A is Bill Miller of Legg Mason, who beat the market for years before holding Bear Stearns (BSC) and Countrywide Financial (CFC) all the way down. He's a smart guy, but perhaps overconfident in his analysis. Take a look at his top holdings, and shudder. Finally, I am not Warren Buffett, so I have limited resources. I'm not prepared to wait for 5 years for Starbucks (SBUX) or Whole Foods (WFMI), once market darlings, to return to glory. That money is better used elsewhere.

IMPATIENT WITH LOSERS AND PATIENT WITH WINNERS

I don't think it's a contradiction to treat winners and losers differently, because the goal is to make money. As Dennis Gartman says, "Be patient with winning trades; be enormously impatient with losing trades. Remember it is quite possible to make large sums trading/investing if we are "right" only 30% of the time, as long as our losses are small and our profits are large."

A good rule of thumb to consider is to use a percentage stop-loss for selling losers, and a trend break for selling winners. That way, you avoid any big losers, but give your winners room to run. A related question, of course, is this: When did you buy the stock? If you bought a dip close to a trend line (say, the 50-day), it's easy to set a stop just below that level. If you bought a parabolic move, you are more likely to get stopped out even if the trend remains intact. Thus, it is wise to buy dips on strong uptrends, or near technical support, because it gives a clearer plan for the exit. Don't let a bad trade turn into a long term "investment".

I generally will sell losers with a 7-8% loss. Sometimes the stock will then turn around, and although that's frustrating, "Opportunities are made up easier than losses." (quoting Todd Harrison of Minyanville.com and his Trading Commandments). And yes, it is mostly for psychological reasons, as I've had losing positions become monkeys on my back in the past, tying up both my money and my emotions. I know myself: If I don't sell a stock with rational discipline at an 8% loss, I will puke it up in disgust at a 15% loss. Again, Dennis Gartman: "Capital comes in two varieties: Mental and that which is in your pocket or account. Of the two types of capital, the mental is the more important and expensive of the two. Holding to losing positions costs measurable sums of actual capital, but it costs immeasurable sums of mental capital."

If setting a percentage loss seems too arbitrary, you can set stops just below moving averages. Most pros use the 50-day moving average. When the 50-day is decisively broken (meaning the stock tries and fails to get back above it), you may be looking at a change in trend. Here are some examples. First, your boy James River Coal (JRCC). During the bull run, it didn't break the 50-day decisively. Now it clearly has (click for chart).

I had a similar experience with Dryships last year. Since the break, DRYS has been muddling with no clear trend (click for chart).

Of course, keep in mind that those are examples of 2 extremely volatile stocks that had meteoric rises. If you pull up charts of oil (USO) or Chipotle (CMG), you'll see the same thing. For the slower moving broad indexes (indices?), like the S&P 500, many pros use the 200-day moving average. For my long term retirement account, I'm using the 200-day as my guide. Example from the 5 year chart of the S&P (click for chart).

One final point. This is a bear market, and a very volatile one at that. It is not surprising that if you have selling discipline you will be whipped out of many new trading positions. I would not recommend dollar-cost averaging down in individual stocks during a bear market. Save that for very long term investments in index funds.

I hope that was stimulating--I'd be interested to hear any feedback, whether in agreement or dissent...

PS: I leave you with 2 more bits of wisdom, somewhat related, once again from Gartman:

To trade successfully, think like a fundamentalist; trade like a technician. It is imperative that we understand the fundamentals driving a trade, but also that we understand the market's technicals. When we do, then, and only then, can we or should we, trade.

Keep your technical systems simple. Complicated systems breed confusion; simplicity breeds elegance.