Use Time-Stops on All Stock Positions
A time-stop is the point in time when you will sell the stock if it does not rise or decline as expected. Most long-term investors have only a fuzzy or general idea of what they expect a stock to do. Traders, on the other hand, look for setups that promise an almost immediate surge in price. If that surge does not take place, then the setup failed to deliver on its promise. The trader cannot afford to leave his assets dormant for months. The money that is tied up in non-performing stocks can cancel part or even all of the gains that could be obtained from the stocks that are rising..
The experienced trader does not trade short-term just to be a short-term trader, though the quick feedback on a trade is an added benefit. He does it to make more money than he could make by being a so-called “long-term” investor. Incidentally, short-term investors may be short-term holders of their individual investments while they are long-term investors. That is, they are short-term investors long-term. If the only difference between the trader and the person who holds positions for a few years were the length of time the positions are held, then the trader would simply be churning his own account. Strangely, that is the way “long-term” investors tend to see traders. However, that is not the real difference. The expert trader trades on the basis of “setups.” Most long-term investors do not know what a “setup” is.
Traders have learned through experience that there are “setups,” or price and volume configurations, that tend to be harbingers of a coming price surge. The surge does not necessarily last a long time, but it may last a week or more. If it is the beginning of a new trend, and setups are often the way a new trend begins, then the move could last a few months. However, the key point is that the setup dramatically increases the odds that a price surge will occur soon. Traders tend to hold short-term because they like to lock in that surge. Once the surge is over, the stock may decline or trade sideways for awhile. Why wait out a decline or a go-nowhere period if there is another setup somewhere else? Hence, the trader sells to lock in his gain, and goes elsewhere to capture another surge. That is the real reason traders trade rather than ride their stocks up and down through many cycles before selling.
When do you pull the plug on a stock investment? Do you sell after a few weeks, a few months, or a few years? This is one of the first principles addressed by the author when instructing new stockdisciplines.com trainees. If your stock is not performing, then its non-performance is impacting your portfolio. For example, say you have $100,000 to invest. If you have 5 stocks that have averaged an appreciation of 5% for the last month, and you have 5 other stocks that have drifted with an average gain of 0%, then the average gain of your portfolio is only 2.5%. If the non-performing stocks have averaged a decline of 2%, then the average return of your portfolio is 1.5% rather than the 5% achieved by your performers. The more time that your portfolio is fully invested in rising stocks, the better the performance of your portfolio will be. Therefore, it is important to eject stocks that are declining and stocks that are drifting as soon as possible.
Assume that you have invested in a stock that has been in a narrow trading range for a year. You purchased because it has just broken out above the upper boundary of its trading range. Not only that, but it also gapped up above that boundary with a 100% increase in volume. You decided that the stock was probably good for a move of at least 10%. However, if the stock drifts for two weeks without continuing with the expected move to the upside, then that setup has failed. Accept it. Once a setup has failed, the setup no longer exists. Since the setup is gone, sell and look for another setup. It is not efficient use of your money to leave it in a stock that is drifting aimlessly. By definition, the “setup” should be a precursor to a surge in price. If it isn’t…adjust to the reality.