Dodge Your Own Market Disaster

Say you decide that you'll be happy with a 30% gain (wouldn't we all?) but are unwilling to take more than a 10% loss. If you bought shares at 100, your exit strategy would have you selling the stock when it reaches either 130 on the upside or 90 on the downside. These limits should be reflected as actual orders placed with your broker, so you don't have to watch the market on a day-to-day basis.

THE EXIT

A sound exit strategy should be carefully thought out. Research different approaches before you choose one (you'll find more articles about market timing at www.working-money.com), and use what you learn to create an exit strategy that works well for you. The following steps will get you started:

1. After buying a stock, place a limit sell order? at your target exit price. When the stock trades at or above your limit price, the order should be executed and the stock sold. Limit orders are executed at your limit price or better. There are occasions when you may sell your stock at a better price. That can happen this way: Suppose you entered a $130 limit sell order. When the markets opened, the price of the stock was $131.50 - higher than your limit order. The order should still be executed at the higher price because the price reached and exceeded the limit of your order.

2. To protect yourself against unusually high losses, use a stop-loss? order placed at your maximum tolerable loss. This can either be a percentage of your investment or a fixed-dollar amount. In this example, the stop-loss would be set at $90 because you are not willing to lose more than $10 on the position.

3. If your time window for the investment is less than two years, it might be to your advantage to use a trailing-stop? order. A trailing stop follows the stock on its way up, from one week or month to the next. As soon as the stock starts to fall, the stop order is triggered and the order executed. You can use different strategies to apply the trailing-stop order:

Use a percentage of the profit you are willing to sacrifice

Assign an absolute dollar amount

Set the stop at the low of x number of days ago (20 days is popular).

Place limit sell and stop-loss orders at
the time you place your entry order.

Place trailing stops when your stock starts
moving up. This helps you avoid sudden
changes in price trends.

As the stock price approaches your target, reevaluate your goal. You might want to adjust the profit point. If you do, be sure to adjust your initial stop (the one you placed at the 10% loss point) as well. It would make sense to move it, at least to the point where you would break even (after costs) if the market were to turn against you.
If the stock price starts falling and you decide that you must exit a position, use a market order. Once panic sets in, prices will fall much faster than they rose. Placing a market order gives you the comfort of knowing that you will be able to get out immediately. In this scenario, the exit itself is more important than the extra nickel or dime that you might get with a limit order.
Remember, a good investment now is not necessarily a good investment forever. In the 1960s and 1970s, portfolio managers thought glamour stocks such as Xerox and Polaroid were no-brainers. These stocks did, in fact, have great runs for a limited period, but their time came and went. Great companies do not necessarily equal great stocks. That's why you need an automated strategy for exiting an investment, both to protect a large part of your profits and to insulate yourself from any major move to the downside - in the stock itself and in the market as a whole.

R.M. Sidewitz is chief executive officer and founder of Qi2 Technologies, LLC, an investment management company, and the managing member of Qi2 Partners LP, a domestic hedge fund. For additional information on long-term investing, go to www.longterminvestor.org.

SUGGESTED READING

Sidewitz, R.M. [2001]. "Is Buy-And-Hold The Strategy For You?" Working Money, Volume 2: April.
_____ [2001]. "Jump In! Jump Out! Using Market Timing," Working Money, Volume 2: May.

Copyright © 2001 Technical Analysis, Inc. All rights reserved.