Last week, a Seeking Alpha reader and newsletter subscriber sent me a question that dogs many investors:
I've now read all your newsletters and it's great info. I'm now becoming more disciplined in my approach to options. If possible please include in your newsletter some info or your opinion of when to take profits with options. For example if you have a 4 to 6 month call option and it increases in value by a substantial amount by month 2 do you take profits on half of your position and keep the rest? Do you close your entire position? Are there some basic rules of thumb that you follow? Thank you and I look forward to your next newsletter.
-Roberto, San Diego, California
Although Roberto focused on options, I can address his question from a broader perspective. In this article, I draw the distinction between short-term trades and long-term investments. Then I consider how I typically proceed in each case, placing focus on long-term conviction plays that have run.
Whether you consider your position a short-term trade or long-term investment, how you handle the exit ends up being a very personal decision. On short-term trades, I contend that, no matter the situation, you should have a hard-and-fast plan. Of course, it can be somewhat case-by-case, but it needs to be clear, easy-to-follow and something you stick to no matter what. Here's how I responded to Roberto to that end, using a trade in Sprint (NYSE:S), in the newsletter:
Generally, on short-term trades, I sell at least 50% of the position after hitting a profit target of between 10% and 50%. Several variables, including size of the trade, amount at risk* and conviction and technical indicators dictate where my profit target falls. I usually sell the rest on weakness, usually defined as a meaningful dip below my initial profit target.
I put an asterisk next to risk because it's an important factor when considering money management issues ... it's important to realize that the cost to enter a trade does not define risk. I define risk as the difference between the cost to enter the trade and my hard or mental stop loss.
On the S trade, I had a pretty tight stop loss. I would have stopped myself out of both legs of the trade the day after S closed below $2.00 and failed to recover and hold above $2.00 the next day. That's approximately a 10% stop loss. Again, the same variables that dictate where I set profit targets influence where I set stop losses, but the general mottoes I live by are:
I expect and take small losses I can easily absorb to avoid potential catastrophic losses and, courtesy of (Robert Weinstein), if you're not leaving money on the table, you're not making money.
Long-term conviction plays do not allow for such clear-cut terms. At least, not in my mind. Sure, you can adapt the terms you use for short-term trades and apply them to long-term investments. You can take a disciplined approach, ignore all other factors and set hard profit targets and stop losses. In the real world, for most investors, I don't think that's a realistic way forward.
I fully realize the response of some ... successful investors stick to a disciplined plan. They get into an investment and know exactly where they will stop out and at what point they'll start taking profits. In theory, that sounds great. On the ground, when human emotion works its way into the mix, not so much. So many things look good on paper, but, in the heat of the moment, it's tough for some of us to even read the words.
Let us consider two different types of stocks. Both have had impressive, albeit different bull runs.
Should I and, if so, when should I sell Apple (NASDAQ:AAPL)?
Great question. Back on April 3, 2011, I wrote an article I hate bringing up so much that I will not even link to it, Why I'm Selling Apple.
I ended up selling my 143 shares of AAPL right around $338. I had a cost basis of $286. I made 18.2%. If I was still holding those shares today, I would be sitting on a 95.1% gain. You can look at that in several ways. Among them:
- Solid trade. You made 18%.
- You idiot. You left a truck load on the table.
I can get behind both pieces of logic. It just depends on the day and my mood. The ultra-disciplined investor would say, "solid trade." Sure, you left cash on the table, but, if you made a habit of abandoning your disciplined approach, you will collect enough losers - stocks that turned against you hard and fast - to more than eradicate the upside you missed in AAPL.
Another person would treat AAPL like a special situation. Sure, discipline is nice, but AAPL is one of those once-in-a-lifetime deals where you just have to let it ride.
On the other hand, let's say you rode Research In Motion (RIMM) past its 3-for-1 stock split in 2007 and owned it at $138 in May 2008. In the world of tech stocks, RIMM proceeded on what you can call a pretty orderly decline. If you had owned RIMM for awhile prior to that 2007-08 period, you did quite well. At that point, however, you might have faced a quandary similar to the one many AAPL investors experience today.
And this is where "on the ground" and "in the heat of the moment" emotion comes into play. You believed in RIM. You wanted to ride the wave because you thought that there was more upside. I would not have called that a crazy belief back in early 2008. I knew more people using Blackberries back then than I did iPhones. RIMM starts falling. Some of us could just cut the cord. I am one of those people. I would have sold, but only if I felt like the long-term story was no longer intact. This is exactly where things get tricky, in two primary respects.
One, we get greedy and we want more upside. That upside does not come. We get greedy and stubborn, as if somehow we are entitled to the upside we lost. Emotion truly takes over and we continue to hold for no good reason other than we want to make back some of the profit that evaporated. That kicks off a cycle that only a team of research psychologists could come close to adequately explaining. And, before we know it, we're sitting on a loss that once was a formidable gain.
Two, we just end up being wrong. With a clear head, you decided to hold because you truly believed in the long-term story. It did not pan out. This is where you can make the strongest case for having a disciplined, methodical approach even on longer-term investments.
Consider Disney (NYSE:DIS). That stock is up again today. It looks ready to flirt with its 52-week high. In three months, DIS has returned more than 16.5%. But, for many, DIS represents a retirement stock. It's a heritage stock that pays a small dividend, one that you would not be crazy to think could increase over time.
If you have built up a nice position in DIS over the years, collected the dividend and maybe generated additional income with covered calls, you feel like you have a good thing going. Personally, I have difficulty selling a stock that I have scaled into over time. You feel like you've done the work and now you're just going to chip away at your lot, reducing the power of compounding. And, of course, I look at the experience I outlined yesterday, involving McDonald's (NYSE:MCD), and think, can this stock (DIS, etc.) be the next MCD?
If you knew DIS was going to head past $100 like MCD has, you would not sell it as it approaches its 52-week high. In fact, this type of strength often portends a move higher. Another case in point, Domino's Pizza (NYSE:DPZ).
I took a disciplined approach with that stock last year. I sold for a roughly 15% gain. I thought to myself, "It cannot keep going higher." And now, it's an hour-long task to figure out how many 52-week highs DPZ has hit over the last 18 months.
While I think I provide some clarity on how I deal with short-term trades, I admittedly leave more questions than answers with my approach to long-term investments. There's a balance I attempt to strike between seeing long-term (as in, multiple year) convictions through and smartly taking profits (or losses) when they stare you in the face. I guess it's a good problem to have. The issue, however, is that hindsight serves as our best guide.
Seeking Alpha provides me with a wealth of knowledge. That's why I bring up these conundrums here. Just as I hope somebody picks something up from what I have to say, I always learn by reading other articles and the almost-always insightful comments that follow.