A basic urging proclaimed on this Stock Market Basics site is “Know when to sell!”
Guidelines are formulated to help make appropriate decisions when situations arise that directly affect your stock holdings, decisions about which you might otherwise be indecisive. They are a safeguard that helps manage risk and once established they should be followed. Especially in the early days of trading, when you are still becoming familiar with the stock market basics, you will be unsure of what to do and when that happens it can be a costly experience.
You may hold a stock that falls unexpectedly in price, closing perhaps as much as 8, 9, 10 percent or more from it’s recent high. It happens from time to time, sometimes over several trading sessions or longer and sometimes in a single day. (Below I will briefly detail one of several that just happened, a few days ago on March 9, 2011 — with the chart of JDSU added to illustrate the event.)
And it happens to every trader, sometimes frequently and in many cases the fall in the price of a stock is not directly connected with the fundamental properties of the stock which may not have changed. And quite often a good case can be made for continuing to hold. As a stockholder, we might tell ourselves that perhaps there has been an irrational reaction to some situation unrelated to the stock and the stock itself has merely encountered a temporary setback and will soon resume its upward path to reach the higher price that was the potential target established when the trade was originally entered into.
That sounds right, doesn’t it? And that may well be what will happen before too long passes — and that is the rationale that guides many “amateur” traders or beginners — who have not yet become familiar with the guidelines suggested in Stock Market Basics and other information sources.
It is hard to take a loss, but follow the guideline and sell !
Trading is a highly speculative activity and to achieve success it is necessary to follow basic guideline that can help manage its inherent risks and to limit losses to within a tolerable range — but at the same time, without exiting a position too soon, allow the capture of a significant amount of any gains that may occur.
Before a trade is entered into, one of the basic guidelines for trading is to know the exit price, based on and dictated by any price reversal from the most recent achieved high price, whatever that price might be. Perhaps that might be more clearly expressed by stating:
When the stock price falls and closes lower by a pre-established percentage amount, or more, from its most recent high, place an order to exit the stock position. Always follow this guideline.
A frequently used percentage is 8% or 9%, but whatever the number chosen, do not deviate, if the stock price falls by 8% or whatever, sell it! Many beginning traders become indecisive when faced with a loss and they hold on with the result that the loss sometimes becomes even greater — and sometimes quickly.
Will the loss be limited to the pre-establish percentage?
Unfortunately not, sometimeds the trading moves too fast to obtain the specified price, or if you only act after seeing end of the day closing prices as many traders do, the stock may have moved lower than the preferred 8 or 9% and the sell order would be placed after you see the action at the next day’s opening of trading. The following JDSU example describes that scenario.
A current example: JDS Uniphase (JDSU)
JDSU stock had traded up to around $27.50 on Friday of last week but on Wednesday it took a 20% drop to down around $22 at the close — that exceeded the 8 or 9% loss for the target exit price but that’s what can happen. As it worked out, it meant that even with the pre-established acceptable loss pegged at 8% or 9%, the best price that could be received the following morning was around $22.37 price, about $3 lower than planned.
Now, the price may quickly go back up but that does not matter, the guidelines must be followed, in this case taking a loss. The guidelines have been proven to work and help preserve working capital, the name of the game — many people have lost their proverbial shirt by not following the basic guidelines, in this case the shirt really being the trading stake, the working capital to stay in the game and be ready to fight another day in the unforgiving trading arena.
Here is a chart that shows the big one-day drop in JDSU — but note the previous gap on February 4, 2011 that took the stock suddenly higher, so it can be seen how big stock price changes occur to the upside as well as to the downside.