How the Smartest Traders Protect Their Gains in Volatile Markets
It’s been said that trading is the hardest way to make easy money. And after more than two decades in the markets, I wholeheartedly agree.
The vast majority of investment advisors, brokers and portfolio managers concentrate nearly all of their efforts on what to buy. They do extensive research and create compelling narratives describing why this or that stock is an excellent choice to own.
Picking the right investment vehicle is certainly an important part of the process. What goes into your portfolio is absolutely critical for success; poor prospects lead to poor results.
Personally, I rely on a proprietary indicator called the Alpha Score to find the best stocks to own. It delivered 16 double-digit winners last year — despite the deteriorating market in the second half of 2015. (You can learn how it did that here.)
But picking the right time to buy is only part of the process. You also have to know the right time to sell.
I’m not the only one who thinks this, either. While very few newsletters or investing services discuss the importance of selling, it’s a popular topic among many of the best investors and traders on the planet.
For example, long-term investing heavyweight Warren Buffett loves telling people the two rules to being a successful investor:
“Rule No. 1: Don’t lose money. Rule No. 2: Don’t forget Rule No. 1.”
Investing legend Ed Seykota has a similar take:
“The elements of good trading are: (1) cutting losses, (2) cutting losses, and (3) cutting losses. If you can follow these three rules, you may have a chance.”
Note how he says you “may” have a chance. That’s how absolutely critical exit rules are to successful investing; without them, you stand no chance.
Now, you may be thinking, “Sure, but is picking good sell rules really as important as picking good stocks?”
The answer: Absolutely. Perhaps even more so.
Van Tharp — a trading psychologist who has studied and modeled world-class traders like Ed Seykota — teamed up with long-term systems trader Chuck LeBeau to show exits have more importance on performance than even position sizing. Position sizing can amplify a system’s return and drawdown, and even modulate its volatility. But it cannot turn a losing system into a winning one.
But exits can.
In his book “Trade Your Way to Financial Freedom,” Van explored this idea further. Working with systems trader Tom Basso, the two created a system with randomized portfolio entries and then used a quantifiable, trend-following exit rule to dictate when to sell. And it was profitable.
Think about that. The buys were totally random. But their system still managed to be profitable. All thanks to the sell rules.
That’s how important good sell rules are… more important even than timing your entries.
So, I’d like to share the sell rules I use in my Alpha Trader service to keep our money where it belongs… in our portfolio, of course.
3 Sell Rules Keep Our Money Where It Belongs
Our trio of sell rules has been designed specifically to generate large, profitable exits on our best investments while pruning losers early.
Sell Rule No. 1 tells us to exit when a stock’s relative strength (RS) score drops below 70 — no questions asked.
The goal of this rule is to ensure we’re only holding stocks in an uptrend with strong momentum — i.e., stocks most likely to outperform the market.
Relative strength is a quantitative measure of price trends, so when RS falls below 70 — which means the stock has not outperformed at least 70% of stocks in our database over the past six months — we sell the position. Basically, that’s our signal that this once-strong trend is headed in the wrong direction — potentially sideways, or worse, down. Either way, we sell the stock, freeing up our capital to invest in greener pastures.
This rule gives strong performers plenty of room to vacillate within their primary uptrend. The majority of the time, this first sell rule will do most of the heavy lifting, rotating us out of stocks with falling momentum and into stocks with more upside potential.
But the volatility must have limits. Otherwise, we risk giving back too much in hard-earned profits. Our second sell rule exists to set those limits and define our risk.
Sell Rule No. 2 tells us to immediately sell any stock that falls 13% from its entry price. Essentially, this is the most we are willing to lose on a new position.
To automate this process, we set a “good till canceled” (GTC) stop-loss order 13% below our entry price after buying any of the Alpha Trader recommendations.
While this significantly caps our losses, we also need to consider the other end of the spectrum — protecting the profits of our biggest winners. Our third sell rule is designed to do exactly that.
Sell Rule No. 3 tells us to exit any stock that closes 25% below its six-month high.
Once an open position has a good rally under its belt, our focus changes from avoiding a significant loss to protecting a significant profit. As a result, a hand-off occurs from our 13% stop-loss to our 25% pullback exit.
Even when a stock has a very strong uptrend, it’s not uncommon for it to experience a standard pullback or two. But a stock — even a very profitable one — declining 25% is showing too much weakness. Its uptrend is in jeopardy, which means it’s time to ring the register and take our hard-earned profits. Without this rule, depending on how quickly and how much a stock has climbed, we could endure a 50% pullback and still not qualify for our first sell rule.
Because we’re dealing with such big moves, this sell rule isn’t triggered often… but when it is, it goes a long way toward keeping us from riding those big winners all the way back down. You can see this in the chart of Bitauto (NYSE: BITA), which I recommended in October 2013.
Again, I can’t stress enough how important exits are to system profitability. The Alpha Score found a huge winner in Bitauto, rode the uptrend and exited correctly. Had we been using a buy-and-hold strategy, we would have given back all our gains, and then some.
Instead, subscribers held tight to their profits and booked a 242% gain.
Combined, Alpha Trader’s three sell rules define our risk, determine the level of volatility we’re willing to accept and help ensure we’re using a very profitable system over the long term. And because our rules are quantifiable — no abstracts here — it means they’re easy to follow, which is one of the keys to successfully running a profitable system.
With the market undergoing big swings, yet not really going anywhere, following a profitable system will likely mean the difference between a winning and losing portfolio this year. As I mentioned, the Alpha Score system delivered 16 double-digit winners in 2015 while the market managed to give back nearly all its gains.
If you’d like more information about how you can put this profitable system to work for you, you can get it here.