The Four PIllars of the Stockscores Approach - When to Exit
Stockscores.com Perspectives for the week ending January 6, 2008
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In this week's issue:
We are now on to the third installment of my series, The Four Pillars of the Stockscores Approach to Trading. First, I looked at when to enter a trade. Last week, I discussed the all important concept of how to manage risk and this week, I look at when to exit. I think exiting the trade is the step that causes the most emotional turmoil for investors because it is the action that puts the score on the board. The exit defines the profitability, or the loss, for the trader.
In last week's discussion of risk management, I emphasized the need to plan for losses (back issues of all weekly newsletters are available in the newsletter area of Stockscores.com for those that have missed previous issues). Exiting at a loss is actually the simplest decision to be made. If the stock moves below the loss limit, as defined by support on the chart, sell. However, taking a loss is never easy; most investors avoid taking losses because of their emotional attachment to money.
Your long term success in the market absolutely depends on your ability to limit losses. I have seen very talented traders, those with an excellent ability to pick the right stocks and read the market, fail because they hung on to losers and let those losers grow. Soon, their capital was gone and they were out of the game. All investors will be wrong some of the time, so the first rule of exiting trades is planning for loss and getting out of the stock when the market tells you that you are wrong.
Let's now look on the bright side and think about how to exit a winner. We want to maximize gain and that means we have to allow for short term pull backs in the interest of the long term trend. We need to be able to differentiate between the pull back and the trend reversal.
A general rule of up trends is that they start slowly and end quickly. That means that many investors sell out of their winners before they have maximized their potential. Your long term success in the market requires you to let your profits run; when you are right you have to stay right.
The typical upward trend starts with some abnormal behavior that breaks the stock out of a trading range. Often, the stock will pull back shortly after the breakout and then bounce and make a second move higher. Neither move is typically intense as the market is not yet sure about the legitimacy of the stock. At this point in the trend, there is a good deal of uncertainty and that will cause volatility in both directions that may shake out the trader who lacks the intestinal fortitude to let the trend develop.
A good stock will eventually go in to a linear trend, one that has upward moves followed by shorter downward pull backs as some investors take profits. However, at this stage, the general trend is a relatively consistent upward move that can be defined by a straight line cutting across the bottoms on the stock chart.
Once this linear trend line has been defined, the rule for exit is relatively simple. Exit if the upward trend line is broken. When looking for this break, it is important to remember that a trend has pull backs that bring it back to the trend line. A trend line break goes deeper; it breaks the cycle of upward moves and pull backs.
If a stock has a hot enough story to really capture the interest of the buyers, it will enjoy a parabolic upward trend. Here, the stock will break out of the linear cycle of rising bottoms and the pace of the upward trend will increase so that the line that cuts across the bottoms is a curve.
In this stage, emotion has started to influence buyers and the stock is likely moving beyond its fair value. The stock is getting dangerous because it may soon suffer a sharp pull back if shareholders all rush for the exit door at the same time. At this stage of the upward trend, the trader needs to take a more aggressive approach to exiting. Since the stock has now run away from its trend line, waiting for a break of the trend line as the cue to sell will leave too much money on the table. Support should now be defined by the lows of the strongest days, those where the stocks made big moves to the upside. In the Stockscores Approach, we call these trigger candles and we sell when we get a close below the low of the last trigger candle.
All traders should keep in mind that you can always buy back a stock that you sell. Selling a stock does not hurt its feelings and you can come back to it again, particularly since the commissions brokerages now charge are so low.
It is important to be patient with your winners. I do not really look to sell a stock until it has achieved a gain that is double my risk amount. So, if I buy a stock at $10 with a plan to exit at a loss if it closes below $9, I will only start to look for an exit signal once the stock is above $12. If you can average a 1 to 2 risk to reward ratio over your trades, you don't even have to be right half of the time to make money in the market.
As with the two other pillars discussed so far in this series, the rules are simple but never seem to be easy to follow. The thing that gets in our way is our emotion; I will discuss ways to overcome that factor next week when I conclude this series.
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Lets go back to AUXL, the stock I have highlighted thus far in the series, to review the exit rules discussed above.Back To Top
1. AUXL
The entry signal on AUXL was July 31st at $17.50 with support at about $15. If the stock has pulled back to close below $15 we would have sold out of the trade at a loss. That meant that the risk per share on this trade was $2.50 and a 2 to 1 risk reward ratio would require a move to at least $22.50. The stock did achieve this very quickly and then went in to a sideways trading range. Upward trend lines are defined by the lows of pull backs so you can draw a line across the bottoms at July 29th, Sept 25th, Nov 17th, Dec 17th and now Friday to define the trend line. We are now seeing a pull back to this well defined, linear upward trend. Based on the trend line, we expect that AUXL should bounce back in the next couple of days; a failure to do that would be a break of the upward trend line that would trigger an exit signal.
Notice that the trend line is linear, that the stock has not run away to the upside so fast that the trend line has gone to a curve. If that occurred, then we would switch our exit rules from looking for a break of the upward trend line to looking for a break of the last trigger candle low.
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References
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Disclaimer
This is not an investment advisory, and should not be used to make
investment decisions. Information in Stockscores Perspectives is often
opinionated and should be considered for information purposes only. No
stock exchange anywhere has approved or disapproved of the information
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in the stocks discussed above and may trade in the stocks mentioned. Don't
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