What Makes My Stock a Sell Candidate?
Knowing when to sell a stock is as important as buying it because if you don't know when to sell a stock, a small loss can grow into a huge one, or you can give back all the paper profit in a stock unnecessarily. Yet few investors have clearly defined sell rules; most just buy a stock and hope for the best. There are three reasons to sell a stock: to cut a loss, to take a profit or to raise funds for a better investment.
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Cut a Loss
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You buy a stock to make money so you expect it to go up. If, instead, it goes down and shows a loss, the question becomes: how low will it go. Investors can rationalize that the decline is temporary, that it is a buying opportunity, but nobody really knows how low a stock can go and theoretically any stock can go down to zero at any time, taking your money with it. The cardinal rule of trading is to cut your losses early on, when the loss is still small.
Take the Profit
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The flip side is that nobody knows how high a stock can go. Different investors have different rules for when to sell and take profits. Many institutional investors use valuation models: as soon as a stock reaches their price target, they sell. Some investors sell when they have a 20 percent profit, others use trailing sell stop orders.
A trailing stop order is a good-till-cancelled order to sell a stock if it declines below a certain price that is initially entered at a certain percentage below the current stock price. As the stock advances, the trailing stop is moved up to maintain the same percentage distance so that a trader keeps the stock as long as it is rising. If the stock declines, it is sold as soon as it reaches the latest stop price.
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Raise Funds
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Sometimes a stock you buy won't decline below your loss cutting threshold, but won't rise either, trading in a narrow range. Should you hold or sell it? If you are fully invested and find a more compelling investment opportunity, it only makes sense to sell a laggard to raise funds for a new investment. But if you still have some uninvested cash, you may want to give your stock a little more time, provided it does not violate your other sell rules.
Selling a Laggard
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If a laggard starts going down, the loss cutting rule kicks in. But if it does not, you can either keep it or sell it anyway. Examine the company's current situation to see if anything has changed--earnings slowdown, competitive products or unfavorable regulation. In other words, would you still buy the stock now? If yes, then you may keep it and give it a little more time. If things have changed and it's no longer a compelling buy candidate, sell it. You can also sell regardless and buy back if the stock finally begins to move up.
Arguing with the Market
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Most investors don't have clearly defined sell rules. They simply buy a stock and hope to strike it rich. If the stock declines instead, they begin to rationalize why it is not a sell candidate and the decline is temporary; some even buy more "on the dip."
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