Ask Colin

You have suggested selling a stock once it starts going sideways. How do you determine when to sell in this situation?

The suggestion of selling out of a stock that stops trending up and starts trading sideways is intended for active traders only. Indeed this is how I put it in the notes with my videotape:

The greatest return will be secured by holding throughout the trend. However, active traders may find the opportunity cost of staying with the stock during the sideways consolidation phases to be unacceptable. This is especially so as these consolidations can sometimes last a year or more. These traders will quit the stock once it is clearly no longer trending and buy back when it again breaks to new high prices. (page 26).

The reference was to growth model stocks, but it could have applied equally to value model stocks that go into a sideways consolidation. The reason that active traders will sell out of consolidations is that they will be trying to keep their money moving upward at all times. They will move from one stock in a mark-up phase to another. If they get it right, their returns will be great enough to overcome the handicap of transaction costs. They will be trying to re-enter the stock if it begins another mark-up phase.

The reality is that this is difficult to do, which is why I suggest that the greatest return is often made by sitting through these consolidations. It involves less time and effort in monitoring positions and making decisions. Transaction costs are avoided. The emotional discipline of having to re-enter a stock at a higher price than you sold out are also avoided. Finally, depending on how you structure your trading/investing, you may be able to take advantage of the capital gains tax regime that applies to investors holding for longer than one year, rather than being taxed on your entire gain as a trader.

Having said that, it may well be that active traders have an investment plan that calls for them to exit stocks that go into consolidations. There are several ways this could be done. My top choices are:

1. Seeing visually that the stock has moved sideways out of the up trend. This sounds as though a trendline would be useful and sometimes it will be, but not all trends describe nice trendlines. However, these stocks all reach a point where the price has gone sideways for so long that it has clearly moved out of the trend. See the first chart in the attached pdf file for an example.

2. A long term moving average (30 weeks or more) that flattens out and perhaps is also running through the consolidation pattern can be a good indicator that the uptrend has finished for the time being. See the second chart in the attached pdf file for an example.

3. A monthly MACD that crosses into sell mode can also be a very good indicator that the uptrend has finished for the time being. See the third chart in the attached pdf file for an example.

You will notice that in each of these three examples, which are in chronological order in the same stock, would have yielded the best result from saying put in the stock, unless you were very good at finding other uptrending stocks and in getting back into the stock when it started up again. Of course, eventually one of these consolidations will fail and you will get a downward breakoout that signals you to sell. In this case you will have been better off to have sold earlier. However, picking the right time is difficult.

Remember also that these decisions are not on/off or in/out decisions. There is nothing to stop you reducing your holding in a consolidation and then increasing it again on a breakout. The profit overall will be a bit less, but you will save more of the profit at the end of the trend. This is a nice compromise between the two approaches of active trading and active investing.

Keywords: