Editor's note: Today, we're sharing another essay from our friends at our corporate affiliate at Chaikin Analytics. In it, Senior Quantitative Analyst Karina Kovalcik explains how having a plan to prevent severe losses – and a strategy to know when it's time to book your winnings – will protect and grow your money over the long term...
Know When to Fold Your Cards and Walk Away By Karina Kovalcik, senior quantitative analyst, Chaikin Analytics
Not long ago, my friend confessed something that no one ever wants to admit... He lost big in the stock market. And he wasn't exaggerating, either... He was down 65% on a position – and yet, he was still holding on. Unfortunately, this isn't the first time I've heard such a story. Many of my friends have confided in me about their market losses over the years. Of course, losing is an unavoidable investing reality. But that doesn't mean you need to let losses wreck your portfolio. While I can't give personal stock advice, I can help you learn what to do in a situation like this. To deal with losses, you need a plan... None of the friends who've confided in me planned ahead for how they would handle losses. They all ran headlong into positions that were "sure to be winners." You need a strategy to avoid – or at least minimize – your losses. It's important to go into every investment with a sound risk-management approach. You should always consider proper position sizing and use stop losses to protect your capital. But I get it... people make mistakes. And before long, like my friends, they're in a deep hole. So how do you handle losses once they've happened? It's simple: You must know when to fold your cards and walk away...
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Many folks fail to consider what it really takes to recover a losing position. Let's pretend we invested in DUD Company at $100 per share. The stock tanked soon after we bought shares. Now, it's down to $50 per share – a 50% loss. However, to get back to our original $100-per-share investment, the stock now must double – a 100% gain. You can see a few basic scenarios in the following table... As the losses get bigger, the hole you must dig yourself out of gets deeper. The key to long-term success is staying disciplined. To do that, I like to follow what I call the "20-35-50" rule. It works like this... If I hit a 20% loss on a stock, I ask myself one question: "Is the reason I bought the stock still true?" I'll stick with it if my answer is a resounding "Yes!" Otherwise, I'll sell and move on. If I answer "Yes!" to that question but the stock continues to drop, I'll hang on until it hits a 35% loss. At that point, the stock would need to appreciate a little more than 50% to get back to breakeven. If I don't believe the stock has a good chance of bouncing back in the next year, I'll fold. And finally, if I wake up one morning and realize that the stock I'm holding is showing a 50% loss, I'll admit that it's time to get out. A stock that goes down 50% isn't likely to double in value in the next year. I've seen folks hold on to positions that would require a 200% gain to get back to breakeven. That's unlikely – especially with a stock that just tanked. Good investors know when to walk away from losing positions. They don't ride them down to zero... And they sure don't wait around for a stock to move up 200% just to get back to breakeven. That's how you'll live to fight another day. And as long as you can minimize your losses, you'll grow your wealth over the long term. But there's another side of the equation... Imagine that you're sitting on a big winner. First off, congratulations! Winning feels great. But now comes the hard part... Should I sell now? Should I sell later? Should I sell at all? It's a great first step to find a stock that pays off. But a lot of traders make the mistake of getting into a winning investment without knowing when to get out. And it can be just as hard as closing a losing trade... When you have a winner, you want to hold on for as long as you can. No one wants to leave money on the table. That's why I use a simple trick to help me know when it's time to book a winner... It works especially well on trades designed to last a few months or less. And it'll give you the confidence to say to yourself, "OK, I won. It's time to move on to the next idea." In short, we can look at the "technicals"... This is all about price action. It can be as simple as seeing how much a stock gained from one day to the next. And it can get more complex, too – from tracking moving averages all the way to recognizing key patterns over long periods. When I'm looking for the right time to close a winning trade, I focus on one key technical indicator. It's called a "Keltner channel." A Keltner channel is made up of three lines. The middle line is an exponential moving average. And the top and bottom lines are based on another technical indicator called "average true range." The math behind it gets a little in the weeds. But using the channel is as easy as it gets. Take a look... When a stock crosses above the top line, I know that a move down is likely just around the corner. And it's even clearer when the stock is trading in a regular pattern between the two bands – like retail juggernaut Walmart (WMT) in the above example. Put simply, the channel is volatility-based. So when the stock crosses above the upper line, you know it has experienced an unusual spike in upward volatility. (The opposite is true when a stock crosses below the lower line.) That usually means a reversal is coming. You can see that this indicator worked well for Walmart over the past year. And I believe you'll find that you can use the Keltner channel with many other stocks and exchange-traded funds, too. It's a near-instant way to answer a simple question... "Is this trade overextended?" Chaikin Analytics founder Marc Chaikin researched the perfect parameters for this technical indicator. So when I find myself asking whether I should sell a stock or not, I look at where the stock is in its normal range. If it's above the range or pretty close, I know it's likely time to sell – especially if it's not a "buy and hold" type of opportunity. It's really that simple. Good investing, Karina Kovalcik Editor's note: Marc believes an event more devastating than a market crash is on the horizon... But the good news is, not all stocks will suffer. In fact, he says this unique situation will create a historic under-the-radar buying opportunity. He went on camera recently to detail everything, including his No. 1 stocks to buy and sell right now. If you missed his presentation, you can watch the replay for a limited time right here. Further Reading Trying to keep up with the investing pros is difficult without access to the best data. That's why Marc Chaikin developed an incredible system to help even the playing field and guide his investment process... Check it out here: The Four Main 'Ingredients' to My Life's Work. "Stock implosions happen," Marc Gerstein writes. Some of your best performers could plummet in just a few days. That's why it's critical that you come up with a solid strategy ahead of time... Read more from the Chaikin Analytics team here: How to Avoid the Metaverse's Next Collapse. |
INSIDE TODAY'S
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