Determining When to Sell a Stock

A trailing stop loss is one of the best modes for limiting losses and securing profits.

Our emotions can sometimes get in the way of good decision making. Be it hope, denial, blind faith or greed, the chemical reactions that dictate our behavior makes buying stocks far easier than selling them.

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Good news is that the solution relies on simple math called a “stop” or stop loss, or the price you will sell a stock fir regardless of what might be happening to the company or the stock market. A trailing stop loss is arguably the best type of stop loss because it adjusts higher as the share price of a stock rises, allowing you to secure profits.

A trailing stop loss is an ideal way to follow an important rule of investing: Limit your losses and preserve your profits.

Here’s a scenario: You buy shares in Acme Bonegraft Company (ABC) for $50. The stock price steadily climbs to $100. Excellent. Now you need to protect your profit.

To establish a trailing stop, you will need to select a percentage, say 25 percent. If the stock price goes down by 25 percent below the highest closing price, you will sell the stock without any qualms.

Remember, ABC is now worth $100 a share. So, your trailing stop is $75, or 25 percent below $100. If the stock falls to $75, you sell it.

But business is good and ABC keeps climbing. It is now worth $200 a share. Your trailing stop is still 25 percent below the highest closing price, which is now $150. If the stock reaches $150 a share, you sell.

Sure, losing $50 per share is not fun. But because you can’t predict whether the price of ABC is going to rise to $300 or plummet to $30, you need to protect your profit. As they say on Wall Street, “nobody ever went broke taking a profit.”

Having a consistent strategy, in the form of a trailing stop, takes the guesswork out of when to sell. There is no thinking involved, no emotions, no falling in love with a particular company. When you hit your trailing stop, you sell. End of the story.

One more suggestion: instead of watching your stocks like a hawk throughout the day, watch them in the evening, after the market closes. Ideally, trailing stops should apply to closing prices, not intraday prices.

What’s so magical about the 25 percent number? Nothing. (Well, there is something, as discussed here). If a stock is very volatile, you could choose a higher trailing stop, say 33 percent. Or, if a particular stock keeps climbing and you are anxious about the market conditions, or you don’t want to risk losing 25 percent of your profits, you could set it at 20 percent, or even 10 percent.

Bottom line: 25 percent is a good compromise: It’s easy to remember, it allows some volatility, and it will always prevent a catastrophic loss.

Of course, there are many other reasons to sell a stock, but they tend to involve emotions or technical data:

• You should sell when you realize that you made a mistake (that’s a big emotion to overcome).
• You should sell when the price-to-earnings (P/E) ratio is insanely high (this is debatable, as a high P/E ratio may not prevent the stock price from climbing higher).
• You should sell when the stock reaches your price target (this is tricky at best).
• You should sell when your investment priorities have shifted (e.g., your risk tolerance decreased).
• You should sell when the company’s fundamentals go south (e.g., profit margin, earnings, cash flow).
• You should sell when a better opportunity comes up (this can be very subjective).

Investing is both an art and a science. Use trailing stops to take the emotion out of your investments, and your finances will be much better off.

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