Buying a stock can be easy. All the latest information is laid out in front of you like a hand of cards. If you don’t like it, you can walk away.
Selling a stock is more of a gamble. By the time you get a glimpse of everyone else’s hands, you’ve already placed your bet.
Different money managers have different views on when to spot a sell signal, but all agree you should have a plan to sell a stock before you buy it.
There are two basic reasons to sell: When a stock goes up and when a stock goes down.
- If a stock rises quickly in a short period of time, many money managers will look at the fundamentals. Since the price of a stock basically reflects the company’s ability to generate earnings in the future, the best gauge is the price-to-earnings ratio. If the price of a stock is low compared to the company’s earnings per share, it could be sustainable. If the price is high compared to earnings, the market may be over-optimistic.
- Technical analysis looks at trends comparing price and volume. If a stock is rising and volume is falling it could signal a trend reversal, and therefore a sell signal.
- Money managers will often buy a stock based on an investment thesis. As an example, a company could have an edge because it dominates a rapidly growing market. If competition comes along and challenges that dominance, the investment thesis breaks and it could be time to sell.
- A rapid stock rise will also increase its weighting in a broader portfolio. A disciplined money manager will often hold an individual stock to a certain weighting – like five per cent. If it grows beyond five per cent of the portfolio, the manager will sell some to bring it back in line.
There’s a psychological element when it comes to selling a stock that has declined. It means admitting you were wrong, which can be very difficult.
- In some cases unforeseen negative events could occur such as a change in regulation, natural disasters or fraud within a company.
- Technical analysis is correct most of the time but isn’t always correct. If a stock falls it could be temporary. The key could be volume: If volume is falling, the trend could be reversing. If volume is steady or increasing, it may be time to sell.
- The stakes are much higher for short sellers: Those who sell borrowed stocks at a high price, return them at a lower price, and pocket the difference.
A short seller makes money when a stock goes down and loses money when a stock goes up. Since there is no limit to how high a stock can go, there is no limit to how much a short seller can lose.
For the short seller with a rising stock, you don’t just walk away. You run.
Dale Jackson is BNN's Personal Investor. Follow him on Twitter @DaleJacksonPI