|Protecting Profits & Avoiding Losses|
Protecting Profits & Avoiding Losses
Please note that we have used historical data. These examples are for educational purposes only.
In the previous issue of the ChartFilter newsletter, I looked at the art of catching an upward trending market wave or zig-zag and going along for the ride. Well, as we all know, all waves must come to an end sometime. The next trick to learning this art of "riding the wave" is figuring out the best time to get off graciously... before getting thrown headfirst into the sand!
How do we determine the right time to take profits and leave a position behind with ease? Or, what if we've taken a position on board a sinking market? How do we prevent taking on big losses? In this issue we'll consider the art of using stops... and getting the timing right. It's a little like forming a lasting relationship... tricky at first, but worth it in the long run.
CURRENT TRENDS - Learning to Place "Stops"
Once you've taken a position in a stock, at some point you'll need to decide when and if you should sell. There are lots of good clues to a market that's about to lose steam and experience a reversal (or a congestive phase). I like to start with three sets of lines/points on a price chart and follow up with a couple of useful indicators. I begin by drawing and identifying the following:
Let's take a look at some charts to illustrate...
Let's say you've purchased a stock and it has made some nice profits... on paper. Although it depends somewhat on your investment style, the chances are pretty good that you'd want to sell a stock close to a peak, especially if it proceeds to makes a big drop. How do you turn those paper profits into real money?
In the previous issue, ChartFilter newsletter #16, we examined a daily chart for Petro-Canada (PCA - TSE), which has been in a nice uptrend for the past year, showing a classic zig-zag bull-market pattern. I've charted the same stock again below, with the long-term trend line (bright blue) and several moving averages.
We can see that the 100 day SMA (Simple Moving Average) provides a key support level, just above the trendline. Based on this observation, the 100 day SMA should be watched carefully. In March 2001, the price crossed down through this SMA 100 line, and a key reversal point was formed below it. This establishes a zone between the SMA 100 and the long-term trendline. The SMA 100 could be considered the first warning of any significant weakness and any break below the long-term trendline would be considered confirmation. Thus, these two lines establish the foundation for this uptrend. If both lines are broken we would be advised to sell our position in this stock.
If you have access to a suitable charting program, a good trick is to find a Moving Average of exactly the right period (50- , 100-, 200-day) to provide key support. Once you've identified a Moving Average which has consistently provided support a number of times, you have a "living" trendline that will keep you on the "right" side of the market. It's worth experimenting with different period MAs to find the right one... IF such a line is crossed, you have a strong warning of a weakening market.
Here's a close-up showing a customized Moving Average for this stock, showing a 180 MA vs 100 day MA. Note how the 180-day line provides a much better fit to the price action and the reversal point.
Now back to the previous chart that we began with... if you are more of a short-term momentum trader or interested in taking profits, you would also be interested in watching the more recent key reversal point - at the $38.50 level. A clear reversal point such as this one provides a good location for a stop-loss. (It's always a good idea to use a stop-loss, preferably as a standing order with your broker, but at the very minimum, as a line on paper. Once you've identified such a line - exit the market as soon as the line is crossed. Emotionally, you'll probably want to hang-on - but if you stick to your plan... this is the difference between capturing your profits vs watching them disappear into thin air.)
So, in this case, you would sell this stock if it fell below the $38.50 level. If the market continues to move upwards, watch for key reversal points being left behind, and place your stops just below these levels. If you have a reversal point in close proximity to a short-term trendline or moving average, all the better. As the market moves upward you "lock-in" more and more of your profits. This is my favourite way of capturing paper profits, and is often referred to as the "trailing stop-loss."
You'll see that I've also charted MACD below the price chart. I've marked the buy and sell signals offered by MACD as small red and green arrows. In this case, you could use MACD as a confirmation of the buy and sell signals offered by the system referred to above: that is the use of trendlines, Moving Averages and Key Reversal Points.
Here's the second stock I charted in the previous issue... PLX (AMEX) -- another stock featuring a strong uptrend since December 1999.
In this case, I've charted Parabolic SAR (blue dots on price chart) in addition to MACD. Parabolic SAR can be thought of as a mathematically-derived "stop" system. You can see that it is relatively meaningless during a sideways trending market, but once a market begins to trend it does offer helpful buy and sell signals. (I also recommend using it in conjunction with ADX/DM)
The premise is that as long as MACD is positive (above the zero line) it is safe to remain in an existing position. When MACD crosses down through the zero line - you have a warning of weakness in the market and time to check the trendlines, MAs, and reversal points. If you have confirming signals, this would be the time to sell.
By using SAR with MACD you can generate confirming signals. As long as MACD is positive, you can usually ignore SAR sell signals. A sell signal (or buy) from MACD and SAR at about the same time, however, is significant and is best heeded!
Once again, I would recommend that you follow this market with a trailing stop-loss to lock-in profits as it gains value. Conversely, if the price fell below $23, according to this chart it would be time to take your profit or minimize any loss.
The art of selling an existing position, and capturing paper profits (or avoiding crippling losses), is as important as buying at the right time and right price in the first place. The use of a system that works, such as the one discussed in this newsletter, makes the job much easier... and much more profitable in the long run.