How to Handle Your Winning Stocks

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With the market's pullback/correction/retreat/whatever-you-want-to-call-it coming to an end, I wanted to review a few ways you can go about handling your stocks ... especially your winners.

Any growth-stock investor worth his salt cuts all his losses short.  Whether it's at 5% or 15%, at some point, any good investor who's going to have success over many years will cut losses.  Also, any investor who's going to make good money in the market takes good-sized positions.  Thus, for purposes of this discussion, I'll assume all losses are cut short, and that position sizes are big enough to matter (each position in the range 7% to 15% of your total portfolio).

So then the question becomes ... how do you handle your winning stocks?  I've been thinking a lot about this subject in recent days and weeks, and I've concluded it comes down to a battle between drawdowns and profit potential.  Let me explain.??On one hand, drawdowns (i.e., selling a certain percent off a stock's peak) can really work against you.  If you buy a stock and it rises 25%, but then it falls 15% off its top and you sell it, your total profit is just 6%.  If you don't sell it until it's down 20%, your profit has been erased; you're back to breakeven.  And that doesn't take into account that, by the time a stock has dropped 20% from its high, it's often wiped out a couple months' worth of gains.

On the flip side, however, is profit potential.  If you take the above paragraph to heart, you'll sell everything as soon as you have any profit at all.  But if you do that, you'll never develop a large winner ... and large winners are where most of an investor's gains come from over the long run.

Thus, there's a natural "tension" between booking profits and letting them run.  So if you want to make big money, you'll need to choose a strategy that can maximize gains while minimizing headaches.

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That leads me to several general strategies you can use to manage your winners.  This won't be as much about specific selling rules as it will be about guidelines for your average winning stock. (I'm happy to write about some technical indicators that can help you sell stocks better in future Advisories.) So here is a range of possibilities to consider.

Strategy 1:
Sell every winner when it rises a certain percent (10% or 15%) from your buy price.

Advantages:
Drawdowns minimized, so portfolio results will be smoother. You will be buying and selling relatively quickly so you can focus on the best set-ups and opportunities and you won't get attached to stocks.

Disadvantages:
No chance of landing a big gain.  Profits in portfolio are totally dependent on "win percentage"-i.e., if half your stocks are losers, which isn't uncommon, you won't make much money.  Very hard to have a truly great year.

What kind of investor it's best for (with a cheesy baseball analogy thrown in): The disciplined stock picker who abhors drawdowns and wants to make relatively consistent profits (though not great profits) over time.  A singles hitter.

My take: Unless you're a nimble short-term trader with great discipline, it's going to be tough to make money if you're cutting every profit short.

Strategy 2:
Sell winners using trailing stops (15% to 20% off a stock's recent peak), or when it falls through support, such as the 50-day moving average.

Advantages:
Opportunity to land big gains. Usually allows you to ride a winner for as long as the stock wants to run.

Disadvantages:   Drawdowns will be horrible. When one stock begins to pull back, chances are your other holdings will do the same.  Thus, a solid portfolio gain (say you're up 20% for the year) can disappear in a hurry since all sell stops will be so far below the stocks' highs.

What kind of investor it's best for (with another cheesy baseball analogy): The investor who's aiming for longer-term returns and doesn't mind seeing 5% or 10% of his portfolio go by the wayside during sharp market corrections.  A power hitter looking for doubles, but who also strikes out a bunch.

My take: In the very long run, this method will produce large gains ... but also choppy gains.  It might not produce any profits for a couple of years, but it can dazzle when it latches onto a few big winners.

Strategy 3:
After buying a stock, average up in price the first couple of times it rises 5% or 10% above your last buy (if you bought at 50, you might buy some more at 55 and then again at 60).  To sell, you use a trailing stop or the 50-day moving average.??

Advantages: Any single big winner (100% increase or more) could drive your portfolio's results for the whole year. Your biggest position sizes will naturally be in the best performers because of averaging up.

Disadvantages:
The vast majority of your stocks will either be losers or breakeven trades.  Only the rare 50% to 100%-plus winner will push your portfolio higher.  Because it could take a year or more to find that winner, your portfolio's returns could be sour for long stretches before striking gold.

What kind of investor it's best for (with yet another baseball analogy): The kind who is solely gunning for huge gains over time, and doesn't care about near-term performance.  Also the kind who recognizes that big winners take TIME to play out even if it's been a year since finding one. The investor must have the patience to ride through a few painful corrections.  A homerun-or-strikeout type of hitter.

My take:
  This method probably produces the very best gains over time.  But the drawdowns and lack of consistent upside mean you need to truly love finding and riding the major winners, and have great confidence in yourself.  It's very tough to pull off.

Strategy 4:
Sell a portion of your winner (one-quarter to one-half) when it's up a reasonable amount (10% to 15%), then ride the rest of the shares using a trailing stop.

Advantages:
Able to sock away a small amount of profit quickly, yet you can still benefit from a big winner.

Disadvantages:
  Your position sizes get reduced quickly, lessening the impact of a big winner.  And the profit taken by selling a small portion of a small winner can be, well, small.

What kind of investor it's best for (with a final baseball analogy thrown in): One who can't stand the volatility of having big positions in a few volatile growth stocks, yet still wants to hit a homerun every now and then.  The all-around hitter who sprays mostly singles, a few doubles, and a homer every now and then.

My take:
This is my preferred method.  My own, personal mindset makes it difficult to constantly aim for big winners, especially when that involves the inevitable 20% correction in leading stocks.

Of course, the above four methods are just the tip of the iceberg-you can delve into a mixture of averaging up and selling on the way up, you can vary position sizes, and so on.  But giving some thought to these portfolio management strategies today will do just as much for you as finding the next hot stock.

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With unemployment rising and real estate prices spiraling south, it's clear the market's volatility is about to increase exponentially-especially headed into the new year.

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For tonight's stock idea, I'm going back to a liquid (i.e., well-traded) leader that I've written about in months past.  Many of these liquid leaders, especially those in the technology arena-stocks like Priceline.com, Baidu, Apple, etc.-have been lagging the market during the past couple of weeks.  And, frankly, many have been moving sideways for the past four to six weeks, thanks to the recent market pullback that came prior to this lagging period.

That action leads us to two possibilities.  The first is that these stocks are actually building multi-week tops, and with market sentiment at nosebleed levels, are giving us early and early indication of an upcoming correction.  And you can bet that if I see more than one or two of these leaders decisively break below their 50-day moving averages on big volume, I'll be peeling back exposure to the market in general.

But, with that said, I think it's too early to conclude these are tops.  They could just be building new launching pads for another upmove!  So, tonight, I wanted to bring up one of these stocks, which good be at a solid buy points.

It's NetApp ( NTAP ) , formerly known as Network Appliance ( NTAP ), and it's emerging as the King of Data Storage.  Sure, EMC and others are still big competitors, but there's plenty of room for everyone.  NetApp's products appear better suited for the new cloud-computing reality, which has led to solid growth during the past few quarters as big corporations have ramped up their technology spending.

In the past four quarters, revenues have ramped higher by 36%, 33%, 36% and 33%, while earnings have gained 43%, 61%, 123% and 41% during the same time.  In fairness, that growth is supposed to slow in the quarters to come, but analysts have been notoriously behind the curve with many names in this sector.

Chart-wise, NTAP's relative performance ( RP ) line-which measures how the stock is performing relative to a major index like the S&P 500 or Wilshire 5000-has been basically flat since the last part of September, similar to many leaders.  The stock itself took a brief hit three weeks ago when its earnings report (due after the closing bell) was somehow leaked in the last hour of trade.  But the stock rebounded nicely after the conference call that night, continued to find support in the days ahead, and has begun to crawl higher in recent days.

The upshot: After a quick shakeout, NTAP looks to be finding support around its 50-day line for the first time since this rally began on September 1.  If you're game, I think you could buy, say, half of what you normal buy here, with a stop around 50-52.  Then you could fill out your position if you see NTAP sport a good gain on above-average volume, which would tell you that institutional investors are building positions.  If the market remains buoyant, liquid names like NTAP could have another leg up.

All the best,

Michael Cintolo
For Cabot Wealth Advisory

P.S. Don't forget to reserve your copy of Cabot's 10 Favorite Low-Priced Stocks for 2011 by December 12, 2010, to get a 15% discount! There's only a few days left, so don't delay. Order now!



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: Investing , Stocks

Referenced Stocks: NTAP , RP

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