Let’s talk about selling stock based on momentum. Knowing when to sell a stock is as important as knowing when to buy, and both of these actions are governed by momentum. You know by now that we measure a stock’s momentum by its relative performance (RP) line, which graphically depicts how a stock has performed relative to a market index. In our quest for profits, of course, we search for stocks that have an up-sloping RP line, meaning they’re outperforming the market as a whole.
Since trends tend to stay in effect, stocks with positive RP lines usually continue higher, and vice versa. For this reason, we use RP lines not only to identify potential purchases, but to identify potential sales as well. When a stock’s momentum turns negative, the odds are that the newly established downtrend will likely persist. That indicates that it’s time to move on.
The trick is selling stock after you have given them every chance to keep advancing. Following the RP line will never get you out of a stock right at the top, it will keep you in strong positions as long as they are strong, getting you out once the chances of a sustained advance are small.
At Cabot, we have several rules we use to determine whether to sell a stock. Every week, Cabot editors meet and check the RP lines of the stocks we follow in our growth publications—Cabot Growth Investor, Cabot Top Ten Trader, and Sector Xpress Cannabis Advisor—to see if they’ve broken any of these rules. If they have, out they go! If you carefully read and understand these rules, you’ll be looking for the exact same things we do, and you’ll know when we find them.
Momentum Turning Down for Eight Weeks
If things are on track with your company and its stock, and perception hasn’t been sharply damaged, then a stock’s RP line should rarely pull back for more than eight weeks. If a stock’s RP line correction lengthens to 10, 12 or 15 weeks, it’s probably telling you that the fundamentals of the company may be changing for worse, due to poor sales or earning, deceleration of growth, etc. When you see an eight-week correction, throw up the safety nets and make sure your stock doesn’t fall much further.
Here’s how to do that. Remember that an RP line correction is counted from the recent peak to a new correction low. So if the RP line bottomed four weeks after it peaked, then moved sideways for three weeks, that is not an eight-week correction. Only if the RP line hits a new correction low eight weeks after its peak has it met the criterion of an eight-week correction.
Next, look at the price chart and set a mental stop slightly below its current price, preferably at an area of support. If the stock closes below this point on any day, you should sell. Mental stops let you hang on to a stock with a lagging RP line as long as the price is still appreciating, not depreciating.
This unique rule was developed after years of watching, drawing and analyzing RP lines. We noticed that after a stock had a meaningful correction of at least four weeks, then rebounded strongly for two weeks, it entered a critical juncture.
At this time, after a correction and short rally, a stock’s positive momentum comes into question. Many stocks continue to advance strongly, breaking through their old RP highs. Others saw their rallies falter and they lost their positive momentum. But how can you tell which way your stock will go?
We found that, following the initial two-week rally, if the stock’s RP line can stay above a 30-degree upward-sloping trend line drawn from its RP low, then holding on is your wisest course. Conversely, if the stock’s RP line breaks down below this trend line, the positive momentum has faded and the stock will likely continue its descent.
Studies of our portfolio actions have shown that selling stock based on the breakdown of the 30-degree line is our best selling rule. We believe this is because the best time to sell a faltering growth stock is when a rally following a correction falters. And that’s exactly what the 30-degree rule allows you to do!
Two RP Tools That Can Help You Sell Right
Cabot Growth Investor’s rules to sell after a 10% to 20% downturn, the eight-week momentum breakdown and the 30-degree line penetration make up our three official rules for selling. There are, however, a couple of tools we use to help us identify trouble before it occurs. We’d like to share those with you as well.
First, we’re always on the lookout for double or triple RP tops. Just as it can be a tip off of weakness when a stock has a tough time getting through a given price level, so it does with RP levels. Often, when a stock’s RP line attempts to get above a certain point two or three times and fails, its run is over and lower prices can be expected.
The second thing we look for is a divergence between the price and RP line. This is a sign that the sponsorship behind the stock is waning—the buying power that previously made the stock outperform the general market has since subsided, creating just an average market performer. This subtle decrease in sponsorship often continues until it’s not so subtle! That means lower prices ahead.
Paying careful attention to RP lines and setting mental stops will help you know when to sell a stock and take those profits. You will be able to hold on to your strong stocks, tolerating their corrections in an ongoing advance. But you will know when to sell the stocks that break the rules and avoid big losses.
We hope that these lessons will help you become a better investor. Our investment advisories can help as well, giving you expert recommendations for when to buy, how much to pay, and when to sell. To browse our library of 15 investment advisories to determine which one is right for your investing style, simply click here.
What is your approach to selling stocks? Are they different from the rules we outlined above? Tell us about it in the comments below.