Knowing when to buy or sell stocks

Many investors in the stock market wrongly believe that their job is done once they buy a stock and the rest is just to wait as the profits roll in.

Nothing could be further from the truth. In fact, the main work begins after you buy a stock because the steps you take after a purchase can mean the difference between a well-earned profit and a disappointing loss.

Usually, you will have bought a stock based on a particular reason. However, it is important to realise that stock prices are affected by many factors, amongst which your reason may happen not to be one.

Therefore, the price may unexpectedly go up or down significantly without your knowledge in which case you will miss a good opportunity for good gains or suffer a heavy loss. So, what can you do to increase your chances of gain and minimize loss?

Two strategies commonly used to guide your position to a profit or keep the loss as small as possible are pyramiding and cutting losses.

Before you enter a trade, you should have decided on two critical prices - your target price if the market favours you and your stop-loss price in case the market goes against your expectations.

Enterprise expounds on the two strategies key to ensure you thrive as an investor in the stock market.

Pyramiding

If the stock price continues to favour you, you can cash out in stages by reducing your position as the price rises. This is called pyramiding or easing out.

Of course, you should have decided on your first target exit position even before you bought the stock. The first exit position should be at the percentage gain you are comfortable with.

Some people may decide to sell half their shares once a gain of 15 per cent is reached while others may do so at 20 per cent or more. 15 per cent is a good starting point because it is above bond rates and inflation combined.

At the second exit, you may sell half the remaining stocks and if the price continues to rise, you can wait to sell the rest at a higher percentage.

By doing this, you will have continuously reduced your risk. Unless you are executing a “one and done” strategy that enters and exits 100 per cent of your position, pyramiding provides an excellent tool for managing to change risk by taking money off the table at regular intervals during the rise.

Cutting losses

When people buy stocks, they rarely think about losing. Yet gaining and losing are two sides of the same coin.

Most traders and investors focus on gaining and gaining alone. The reality however is that anyone can lose money in the market, whether they are a seasoned investor or just a beginner.

What usually separates the winner and the loser is the aspect of cutting losses. Cutting losses is simply the act of selling your stocks at a predetermined price which is usually termed as a stop-loss.

Preferably, the stop-loss should not go beyond a 10 per cent loss. Under 10 per cent, the percentage increase needed to get back to even is more or less the same. Beyond 10 per cent, the percentage increase needed to get back to square one starts going up rapidly.

The higher the loss you allow, the harder and more time it will take to get back to even. What a waste of time and exposure to anxiety!

Knowing the exit price

Before you buy a stock, it is important to know the price at which you will exit should the market go against you. That way, the market never gets you unprepared.

More than anything else, the failure to cut losses is what has led many to financial ruin in the stock market. People just watch prices going down without taking action.

They stick to the hope that the market will reverse and move in their favour. Hope is not a strategy in stocks and in addition, there is no guarantee that a stock that has gone down will not go down further.

Those who are aware of this fact always cut their losses small. They know they can always buy back the stock further down should they still be interested. After all, the fact that you have exited a stock does not mean you cannot buy it again. William J. O’Neil, the author of the book How to Trade Stocks, says that “the whole secret to winning in stocks is to lose the least amount possible when you are not right.”

To sum it up, legendary American investor George Soros says: “It is not whether you are right or wrong that is important, but how much you make when you are right and how much you lose when you are wrong.”

Pyramiding and cutting losses are two money management strategies in stock trading that will greatly increase your probability of success in stocks while at the same time protecting your capital and the gains made.

Respectively, they offer an offence and defence strategy required to win in stocks.

-Peter Wambu is the Author of the book, The Ultimate Framework for Success in Shares.