How to Avoid Turning a Big Win into a Wipeout

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You may struggle with the following question…

Of all the things I could ask, this is the one that leaves many traders speechless.

OK, here it is…

When do you sell a winning trade?

Many people can’t respond with conviction. While they can typically describe their strategy for buying, a clear plan for selling is often harder to explain.

And it’s not just retail traders…many professionals have a similar problem.

Market data firm FactSet did a study of broker research for S&P 500 stocks. It turns out that even during the GFC sell-off, less than 10% of companies had a ‘sell’ recommendation.

On the flipside, since 2002, typically over half the S&P 500 stocks have been a ‘buy’. With such a lopsided focus on entries, it’s easy to see why exits are often an afterthought.

But here’s the thing: You don’t make money when you buy — you make it when you sell.

I’ve seen many traders come and go over the years. One of the leading reasons they fail is due to poor exits. Their mistake often comes down to one of two things:

  1. Cutting profitable trades too early; or
  2. Riding a stock up…then all the way back down.

For many, selling is the weakest part of their strategy.

Don’t worry if this applies to you. I have a strategy that could help. It’s the single best way I know to maximise your upside, while limiting your risk. I’ll tell you more in a moment.

But first, I’m going to tell you a story. It will help reinforce why exits matter so much.

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From hero to zero

I remember talking to a trader — let’s call him Ted — in early 2009. The GFC had hit mining stocks hard. Many were trading at bargain-basement prices.

Ted was telling me about a stock he was buying. The company was iron ore miner Atlas Iron Ltd [ASX:AGO]. It was trading about 70% below its boom-time high.

Atlas had a compelling story. It had loads of cash and a low valuation. The shares were also turning higher after months of selling. I even bought a few for myself.

And do you know what? Ted was right. AGO rose by nearly 240% in two years.

I ran into Ted a few years later. After some initial banter, I said: ‘How about Atlas Iron? You got that right!’ Ted just looked at the ground in silence.

I knew instantly…he hadn’t sold. Ted rode the boom, and then held on for an almighty bust.

Atlas Iron no longer exists — the company was eventually taken over for a pittance. Not having an exit strategy cost Ted dearly. His shares were practically worthless.

You might be wondering how I went…

Well, my entry was at $1.35 in April 2009. The share price hit my trailing stop at $2.80 in December 2011. I did a bit better than doubling my money.

No, I didn’t get out at the high. I never do. That’s not how I trade.

Instead, I aim for the big mid-trend advance. That’s where I typically make the most money.

Quant Trader uses the same strategy. It doesn’t try to buy at the low and sell at the high — no one consistently does that. The aim is to profit from what’s in between.

Pinpoint selling

Last week’s update was about ‘bagging the elephant’. My aim was to get you thinking about triple-digit gains. These are entirely possible when you know how.

It’s now time to go a step further. I’m going to explain Quant Trader’s exit strategy. I want you to see how it can potentially turn a small profit into a massive one.

But first, let me refresh your memory:

Money Morning

[Click to open new window]

This is chart you saw last week: It’s for Pinnacle Investment Management Group Ltd [ASX:PNI].

Remember, this is an example from Quant Trader’s live signals. You may have even had this in your portfolio. This is an example of what’s possible when you have a plan to sell.

Now, PNI had three entry points — $2.00, $2.32 and $2.54. While these were good buying levels, they are not the most important part of the trade.

You see, the key to it all is the exit strategy. This is what determines the size of the profit.

Look closely at the red line below the share price. It resembles a set of rising stairs. This is the trailing stop. And it can potentially turn your entries into a lot of money.

Now, just to briefly explain: Quant Trader has an algorithm that calculates the trailing stop. The formula uses a stock’s daily trading ranges, so it’s unique to each situation.

Another popular strategy is the fixed percentage trailing stop. The idea is to sell when a stock falls by a set percentage from the previous high (e.g. exit if the shares drop by 25%).

I’ll talk more about setting trailing stops another day. But for now, I’ll just focus on the concept.

So how can a trailing stop help?

Well, you might think PNI looks like an easy trade. The trend appears to rise steadily higher. Many people will say, with hindsight, that it’s simple to profit from this type of situation.

But that’s not entirely true.

You see, big uptrends can be deceptive. They mask many corrections along the way.

Take PNI for instance. The shares didn’t trade higher day after day. There were seven double-digit pullbacks along the way. The largest of these was 19%.

Now ask yourself: How would these pullbacks affect your exit strategy?

I’ll tell you what many people do, they sell.

You see, corrections have a habit of shaking people out of their trades. They make people worry that a bigger fall is coming, and this often causes them to sell their shares too early.

Much of the time though, they end up watching their old shares rally to new highs.

But a trailing stop could make all the difference.

Have another look at the chart:

Money Morning

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You’ll notice the trailing stop ratchets higher with the share price. Quant Trader will stay in the trade until the shares touch the red line.

People sometimes tell me that the trailing stop is always late to sell. And they’re right. PNI’s peak was at $8.60. Quant Trader’s exit was 33% below this, at $5.76.

But, you know what?

Being a late seller is often better than exiting early. The reason Quant Trader got three triple-digit gains was because it was slow to sell — this was the key to a big profit.

Trailing stops have two aims:

  1. Keep you in a trade for longer, and
  2. Protect most of your capital when a trend appears to end.

People say it’s all about when you buy…they believe this is how you make money. But I disagree. I believe your exit strategy is the key to making triple-digit gains.

Pinnacle is the perfect example. No entry method could predict PNI would more than double in two years. This gain highlights the advantage a trailing stop could give you.

A trailing stop strategy is the best way I know to both ‘bag the elephant’, and manage your downside. And it will also help ensure you don’t end up like my friend Ted!

Until next week,

Jason McIntosh,
Editor, Quant Trader

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