The Most Important Investment Strategy of All

Businessman analyzing investment charts at his workplace

Knowing when to sell is vital. It’s arguably the most important decision a trader can make.

Many traders fail due to a poor exit strategy. Their mistake usually comes down to one of three things:

  1. Holding losing trades too long
  2. Cutting profitable trades too early
  3. Riding a stock up…then all the way back down

It all seems so obvious in hindsight. But why do so many people get it wrong?

I’ll explain a particular exit strategy in a minute. This method is ideal for capturing big moves. It’s made me a lot of money over the years.

But first, let me tell you a story. It will help reinforce why exits are so important.

I remember talking to a trader — let’s call him Ted — in early 2009. The GFC had hit mining stocks hard. Many were at rock-bottom prices.

Ted was telling me about a stock he was buying. The company was iron ore miner Atlas Iron [ASX:AGO]. It was trading about 70% below its boom-time high from the previous year.

The case for buying was compelling. I even bought a few for myself.

Ted was right — AGO took off. The shares rose by about 240% in two years.

I ran into Ted by chance a few of months ago. It had been a long time since I’d seen him. We had a short initial banter. I then said, ‘How about Atlas Iron, you got that right!’.

Ted just looked at the ground. I knew instantly he hadn’t sold. He rode the boom then held on for the bust.

AGO was trading at about 14 cents. Ted’s stock was down close to 90% from his entry level. It was a disaster…he didn’t have an exit strategy.

You might be wondering how I went. Well I bought at $1.35 in April 2009. My trailing stop got hit in December 2011 at $2.80. I did a bit better than doubling my money.

No, I didn’t get the high. I never do. That’s not how I trade.

I aim for the big chunk in the middle. That’s where you typically make the most money. And my exit strategy maximises the chances of doing this.

Let me show you what I mean. The example you’re about to see is from back-testing for my trading system — Quant Trader.

The system uses a series of algorithms to calculate the exit level. The main input is a stock’s recent trading ranges. This makes it unique to each trade.

Have a look at the following chart. It’s for pizza company Dominos [ASX: DMP].

This looks like an easy trade at first glance. It’s a nice smooth upward trend that runs a long way.

You’ll notice the trailing stop…it’s the red line that ratchets higher with the share price. This is the selling point. You sell when the share price touches that line.

This is clearly a big move. The shares rally from $5.77 to a final exit price of $22.26. That’s a rise of 285%.

People often ask why the trailing stop doesn’t rise faster. They want to know why I don’t set the algorithms to quickly lock in a profit.

This is a good question. Let me show you another chart. It shows what happens when I bring the trailing stop 50% closer.

What a difference a tighter stop makes. It reduces a 285% gain to a modest profit of 6%.
You’ll also see a signal for a new trade a few months later at a higher price.

This is why I set trailing stops at a fair distance.

It’s really very simple. If you want to ride big trends, you need to give the market room to move.

Let me show you one more example. This is a recent trade from my Quant Trader service.

The first signal is already 20% higher. The second signal is around the current share price.

Here’s the trade chart.

The stock is an emerging energy company — ERM Power [ASX:EPW]. It’s core business is the sale and generation of power.

The key feature on this chart is the red line under the share price. This is the trailing stop. The stock will remain a hold as long as the shares stay above the red line. No one knows how far this trend will extend. It may do nothing more…or it could be bigger than the Domino’s trade. Time will tell.

But I know this. My system will give this trend every chance. That’s how you capture the big moves.

So forget about trying to hang on to every dollar of profit. Tight trailing stops usually mean relatively small gains.

You need to be willing to give some profit back. That’s how you stay on the stocks that double, treble, and more.

The trailing stop also makes sure you don’t end up like my friend Ted!

Until next week,

Jason McIntosh
Editor, Quant Trader

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The Daily Reckoning
The Daily Reckoning offers an independent and critical perspective on the Australian and global investment markets. Slightly offbeat and far from institutional, The Daily Reckoning delivers you straight-forward, humorous, and useful investment insights from a world wide network of analysts, contrarians, and successful investors. Founded in 1999, The Daily Reckoning is published in 7 countries with a worldwide readership of almost 1 million people.

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