How do you know when to sell a stock?
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You may think owning stocks is all about making money. True, you may be looking for capital appreciation, but if you lose more than you gain, it is all for naught. Top priorities should be to manage risk, preserve capital and take losses quickly.
When To Sell And Take A Loss
According to IBD founder William O'Neil's rule in "How to Make Money in Stocks," you should sell a stock when you are down 7% or 8% from your purchase price, no exceptions. Having a rule in place ahead of time can help prevent an emotional decision to hang on too long.
It should be: Sell now, ask questions later. By limiting losses to 7% or even less, you can avoid getting caught up in big market declines.
Some investors may feel they haven't lost money unless they sell their shares. They hold on with the hope it goes back up so they can break even. But it's still a loss if the current price is below your purchase price.
You may ask the rhetorical question: How low can it go? Actually, it can go to zero.
Ask yourself: Would I buy this stock, right here, right now? If the answer is no, sell it. The time you spend waiting and hoping it will come back, is an opportunity cost to deploy the capital elsewhere, O'Neil advised.
It Takes More To Come Back When You Sell A Stock Too Late
The more a stock falls, the more ground it has to recoup.
If you purchased a stock for 100 and it drops to 90, that's a 10 point drop representing a 10% loss. It looks like you have to make up 10 points to be back to even. But that same 10-point move now represents 11.1% of the now-90 stock. Therefore, you need to have an 11.1% gain, not just 10%.
If it drops further to 80, that 20 move equals a 25% gain you must achieve to get back to break even, and so on. The percentage decline accelerates as you lose more.
You can see how this can get ugly fast.The key is to stop the bleeding, cut your losses and move on.
Domino's Hits A Sell Signal
Domino's Pizza (DPZ) broke out of a flat base Dec. 27, 2021 (1). Shares climbed only 3% above the 549.51 buy point before they started to roll over.
On Jan. 5, Stephens & Co. downgraded DPZ to underweight from equal-weight with a price target of $500, adding to the drop in the stock which started Jan. 3. The stock picked up downward momentum on Jan. 4 with a 28% spike in volume. It continued to drop, falling below the 50-day moving average. on Jan. 5.
It closed at 520.53 on Jan. 5, down 8.3% from the high (2). This was the time to sell. On Jan. 11, Domino's cited "unprecedented" expected increased food costs of 8%-10% in 2022. A few days later, Morgan Stanley downgraded Domino's from overweight to equal-weight, and cut its price target from 545 to 535.
It continued it's drop to a low of 321.15 on May 12, 2022 for a total decline of 43.4%, peak to trough. You could have avoided this massive decline, if you sold using the 8% sell rule.
You Don't Always Have To Be Right When You Sell A Stock
According to Bernard Baruch, a famous Wall Street investor, you only need three to four winning trades out of 10 to make a healthy overall return.
By following a 3-to-1 ratio of gainers to losers, if you have a 25% gain, you can allow up to an 8% loss, and no more. If in an unfavorable market and your winners are only up 10% to 15%, you need to cut losses sooner. This would amount to only 2%-3% down, to keep the ratio intact.
All this sounds good, but in practice it can be hard to admit you're wrong. Trading is an emotional activity filled with ego and the desire to be right. The key is to be steadfast and disciplined in following your rules so you can be around to trade another day.
This article was originally published April 20, 2023, and has been updated.
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