One of the most difficult decisions to make when you go long on a stock is when to sell. This decision becomes even more difficult when a stock is breaking out and there is no top in sight. A lot of investors will tell you to plan when you want to get in and out of a stock. If it is your goal to make 20% profits, you should exit the stock when you are up 20%. I don’t fully agree with this strategy as you can often sell yourself short when you take this approach. The strategy is safe, which is good, but sometimes it is too safe. If safety is your main focus, you should utilize this strategy, however, safety and penny stocks are antonymous. A lot of the times, your profit goal is an arbitrary number. Unless you have mastered the markets and know that your stock will drop after reaching 20% gains, you may want to pay closer attention to the price movement. So, when should you take profits?
There is no “one-size-fits-all” answer to this question. Not every trade will be the same. You should watch the price action closely, and pay very close attention to a level 2 screen if you can. Here are a few reasons I will sell:
The stock is nearing a known resistance level
A resistance level is a stock’s top price based on historical price action. This is the level where more sellers enter the market and less buyers are present. If I am playing the volatility of a stock, and it is nearing a known resistance level, I will usually sell to lock in profits. I make exceptions to this rule when there is a specific catalyst that I believe will help the stock break through the level of resistance. Quite frequently, stocks trade in a cyclical fashion until a catalyst prompts them to do otherwise. For these kinds of stocks, it is my goal to buy at support levels and sell at resistance levels. You may sell yourself short every now and then, but you can’t complain if your taking profits.
A Negative Catalyst Is Approaching
If I believe a stock has a negative catalyst in its near future, I will sell just to be safe. A negative catalyst is anything that damages positive investor sentiment. This can be anything from bad earnings to a bad company update. Often times, penny stock traders are overly optimistic and they ignore the negativity surrounding their stock because they are blinded by greed. A negative catalyst doesn’t have to be directly negative. Instead, it can be the absence of an expected positive catalyst. For example, if a company’s earnings are due within the week, many investors may get overexcited and push the stock price up. If I don’t believe that the earnings will justify the run up, I will sell my shares. Sometimes, a huge company event is expected, such as an exceptionally large business deal. Penny stock traders will push the stock price up in anticipation of the deal, and some will forget that the deal is not a sure thing. I will sell my position when I believe that the stock has overextended itself. Selling in anticipation of bad news can cost you profits, but it can also keep you safe from large drops. Penny stock markets are extremely volatile so a safe strategy is crucial to your survival.
Investors are Getting Bored
In another post, I discuss the importance of investor sentiment. When a stock trades sideways for a long time, penny stock traders get bored. A lot of penny stock traders are day traders that play many different stock picks. When a penny stock is not exciting, these traders may exit their position to play other picks. When many investors exit a stock, a price drop is inevitable. If a stock was recently promoted by a newsletter, it is even more prone to this trend.
The Stock Goes from Undervalued to Overvalued
One of my trading strategies is to find undervalued penny stocks with strong fundamentals. They are rare in penny stock markets, but they are definitely there. I use the market cap, company financials, and a few other factors as the basis for my valuation. When I find these companies, I will load up on shares when I believe the company is undervalued. These kinds of stocks are prone to breakouts. Sometimes these breakouts can cause the stock to go from undervalued to overvalued. In these cases, I will sell because the stock did exactly what I wanted it to. I bought the stock because it was undervalued. Once it becomes overvalued, I have no reason to hold it anymore. I use market cap as the basis for valuation during runs, however, as discussed in this post, market cap does not always matter.
A Large Seller Enters the Market
This rationale applies mostly to intraday trades. If I plan to hold a stock for days or weeks, I will probably not utilize this strategy. That being said, the strategy is incredibly simple. When a stock is breaking out, it can sometimes hit what traders call a “wall.” A wall is simply a large sell order on the ask. If a stock is running and someone tries to unload shares that account for a good percentage of the daily trading volume, I will sell exit my position. For example, let’s say a stock trades about 20,000,000 shares each day. The stock opens at $0.05 and runs to $0.06. At $0.06, there is a seller that tries to unload 1-2 million shares (5-10% of the daily trading volume). At this point, buyers are not able to break through the wall on the ask and the stock trades sideways for a bit. I will sell my shares, as will other traders. This causes the price to drop, meaning it is a good time to get out. The rationale being that getting past this wall doesn’t seem viable. This means that the price will either trade sideways or go down; both of which give me no reason to hold my shares.
I’d Prefer My Current Profits to Smaller Profits or Losses
When stocks are breaking out, it can be very difficult to know how high the stock will run. It is even more difficult when a stock is setting new highs and no resistance level is in sight. This is when traders get greedy. It is important to remember that stocks will not run forever, and unless you are playing a long term pick, you will need to take profits at one point or another. I’ll start taking profits when I have a considerable gain. It’s better to take a smaller profit than to lose all of your gains. Here is a fictional example. Let’s say you buy 10,000 shares of a stock at $3. The stock starts to run and breaks through it’s 52-week high at $4 and upward momentum is still strong. As the stock approaches $5, I will start to minimize my position in case a new resistance level is formed. For this example, let’s say I sell 5000 shares at $5. The stock continues to run and approaches $6. At this point the upward momentum begins to fade. Now, I will sell my remaining shares. Sure, the stock could run to $7, $8, $9, $10, or further, but is it worth risking your gains? It is better to lock in sizable gains, especially when a drop is possible. You need to avoid the “I could have made “x amount” if I held” mentality. Which would you regret more: taking a nice profit, or losing all of your gains? Keep in mind that the numbers above are completely fictional. When I am actually playing a pick, I will play very close attention to the level 2 price action to see how the market reacts to new price levels and make trades accordingly.
These are just a few of the reasons I will take profits on a stock. Some of the reasons can also be applied to taking small losses. Keep in mind, that these rules are all speculative and you should pay close attention to the price action. Level 2 analysis is crucial in my opinion. These strategies will not work for every trade, however, they have helped me with a lot of my trades. Don’t think of these strategies as “rules.” Think of them as ideas to contemplate when considering an exit.