Trade Management - How To Sell and Take Profits
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Hello and welcome back.
In this review we look at another Dr Alexander Elder book, The New Sell and Sell Short, with particular focus on taking profits and cutting losses.
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Dr Elder is a professional trader and psychiatrist, he puts focus onto three areas: Technical analysis, Psychology, and risk management. Without all three of these you are arguably destined to fail.
There is also discussion on what Dr Elder describes as the Three Great Divides in trading, he classes them as:
Technical vs Fundamental analysis
Trend vs Counter Trend
And Discretionary vs Systematic trading.
Dr Elder himself says his strategy is predominantly discretionary, based on technical analysis and is generally counter trend, although appreciates an argument can be made for any combination. My strategy for example includes elements of each, other than counter trend, but all equally have their own merits.
Dr Elder looks at each of the following technical aspects when considering a trade, and suggests trying to keep to five or less criteria. “More is less, anymore just causes confusion”.
Let us look at some of this criterion and how Dr Elder uses them to trade stocks.
First we look at the use of the exponential moving averages. Dr Elder uses both the 13 period and the 26 period for each average.
The exponential moving average is preferred over the simple moving average because it places more emphasis on the most recent set of price data. The simple moving average on the other hand, places equal weighting across all the price points within the data set being measured.
My preference also lies with the exponential averages, purely because there is more significance in the most recent price data.
Dr Elder places both the 13 and 26 period EMA onto every chart, and calls the space in between each EMA the Value Zone. He says:
“When prices dip into the zone between the two lines during an uptrend, they identify good buying opportunities”.
He provides a working example in the book, which shows the buying opportunities at points A. Also suggesting that any move too far away from the value zone should be considered overbought, seen at point B.
As you may expect, Dr Elder suggests overbought prices would be a good time to sell your position, therefore this point B area becomes a sell zone. The sell zone is simply a channel (or envelope) drawn parallel to the moving averages or value zone. However the trigger to sell would be at the first failed attempt of a new high. Likely to be at these points throughout the upward trend.
To recap, he buys in the value zone, creates an overbought zone parallel to the moving average line, waits for price to reach the zone, and sells at the first failure of a new high.
Dr Elder aligns this theory to the extension of a rubber band, and says: -
“You can see that prices almost always get only so far away from the EMA before they snap back”.
Next we have the Force Index, a formula developed by Dr Elder which was published in his previous book Trading For A Living.
The index combines price and volume to determine how much power is behind a price move. Classed as an oscillator, the Force Index fluctuates between negative and positive territory. A rising force index above zero indicates rising prices, whilst a falling index below zero indicates falling prices.
A spike in the index can indicate a strong breakout.
Using a recent trade in our group; United Therapeutics, we can see the Force Index in action.
We took a position here after a 12-week consolidation breakout, and although the Force Index is not something we considered in the trade, we can see how the index gave a considerable spike whilst being above zero. This indicated a strong breakout and is something Dr Elder shows keen interest in when considering a breakout trade.
We can also see how a downturn in the index, but this time below zero, indicates falling prices. Not an ideal time to enter a trade.
For those interested in filtering stocks through the Force Index, I’ll leave some links below.
Dr Elder also has two specific money management rules, rules in which he is consistent with throughout his books. The first is regarding positional risk, to which he says you must never risk more than 2% of your equity on any position.
The key word here is risk, and not positional size.
Let us take a $10,000 account. A 2% risk would therefore equal $200.
The position size however could perhaps be $2000, meaning that there is a 10% stop loss in place, which takes us back to the 2% or $200 risk.
Here we see a snippet from my current portfolio, it shows an initial risk % per position which equates to an average risk of 1.26%, well within the maximum 2% Dr Elder encourages.
The second rule is what Dr elder refers to as the 6% rule.
The rule suggests that if in any given month you lose an accumulative 6% of the monthly starting balance, you stop trading until the following month.
Whilst I find this sound advice for a beginning trader, I’m not entirely convinced that it works for a professional. It is for example entirely possible to have three losing trades in a row and this could put the 6% loss within the first few days of the month. The opportunity cost of missing other trades during the rest of the month could be considerable.
I think its great for minimising risk but questionable regarding overall return.
Let us move on to the chapter How To Sell.
Dr Elder starts by saying:
“You need to write down a selling plan ‘before’ you place your buy order”.
The worst possible time to decide on how you are going to exit a trade is either when the stock price starts to plummet or when the price trends rapidly upwards. In either scenario the ability to make a rational decision is near impossible. There could be thoughts of a rebound and selling too early, or thoughts of a retracement which again could lead to a poorly timed trade.
The first rule is simple, you must have a plan. As soon as hesitation or elements of subjectivity arise, trouble is around the corner.
So when should we sell?
Dr Elder divides selling rules into three categories.
1. Sell at a target above the current price.
2. Sell below the current price using a protective stop
And 3. Sell because the market condition has changed, or as Dr Elder says, ‘selling when the engine gets noisy’.
Personally, I tend not to use a target, I believe a target limits the upside which in turn can stunt the risk reward ratio. I prefer only to limit the downside, with either a protective stop, or a clear indication that the market condition has changed.
Targets and protective stop losses are widely spoken about, whereas market condition (or engine noise) is often overlooked as being a reason to sell.
The term Engine Noise is used by Dr Elder to describe the various nuances of market behaviour, behaviour which when interpreted correctly could give reason to sell a position.
Imagine driving a car, and after some time into the journey the engine starts to make a noise. You may slow down, perhaps even look in the engine. You continue the journey but this time the noise, vibration, and loss of power from the engine becomes unbearable. In most instances we would stop the journey and seek help.
We can relate the engine noises to the market, noise for instance could be news, vibration could be price volatility and the loss of power could equally be a loss of momentum.
Trader behaviour however is often different to that of a driver, they often ignore the warnings, or worse put their foot on the gas and crash.
Dr Elder says; “Continuing to drive while ignoring the signs of danger could lead to serious damage down the road”.
But what are the signs and how do we interpret engine noise?
In simple terms, engine noise is presented through price, when price behaves differently than normal it is described as noise.
This chart demonstrates how one of our group selections, Qualcomm Incorporated, experienced engine noise and was sold as a result.
We entered the trade on a weekly breakout with volume in July 2020, the price (or engine) ticked over nicely until the end of January 2021. We then saw two considerable down weeks providing our engine noise.
The signal which confirms to me that the engine power has finally failed, is by the cross down of the weekly mack dee. We never want to be in a position which has lost its momentum, a loss of momentum results in poor performance.
We exited the trade by raising the stop loss under the wick of the closing candle, aligned to that of the mack dee cross down, a process I stick to religiously.
We exited the trade two weeks later when the stop was hit.
Although I’m digressing slightly, I think this is an important point and is something Dr Elder alluded to; This trade provided an annualised return of 62.96%, but if we stayed in the trade and ignored the engine noise, the return would have dropped to an annualised return of 37.29%. The following 10 weeks after exiting the trade would have seen considerable opportunity cost, meaning our cash would have been at best idle, whereas we could have been invested in another stock showing positive momentum.
The key is to always keep your cash moving in the right direction, any loss of power and we should be looking for the exit.
Dr Elder provides a chart in which he shows his interpretation of noise and reason to sell.
In particular, he looks for a bearish divergence in the mack dee lines. We can see here how the mack dee lines are trending down, whereas price is trending up. This is classed as a bearish divergence and a warning that price could decline.
Confirmation that the noise is too much comes in the way of the EMA crossover. This happens when the 13 period EMA crosses over the 26 period EMA.
The divergence and moving average crossover are seen as not only signals to exit your position, but also a reason to sell short a position, a strategy discussed later in his book.
The main takeaway from the book is to ensure we always have a plan of when to sell, the initial hard stop is often the easy part, the difficult part is exiting a trade as it matures.
Decide on an exit plan, write it down and take away the subjectivity.
Thanks for listening.
Financial Wisdom