There is an overwhelming volume of discourse about initiating positions. Investors are encouraged to buy or short stocks for various reasons. There is, however, a paucity of discussion about when to close out a position. This article will examine the optimal time to sell long positions and to cover shorts.
Ideally, an investor should have a larger long position in a stock the further its market price is below the price target. Similarly, we would want a larger short position the further the market price is above the price target. Assuming that an investor wants to maintain a certain amount of diversification, maximal allocations must also be established.
Here is a graph of optimal position size for any given market price.
Allow me to explain aspects of this graph in more detail.
The line represents the ideal allocation of a portfolio into a specific stock at a given market price. There are reasons that the line of optimal allocation looks like this. Let us detail the reasoning behind each portion of the graph, from left to right.
Assume there is a stock that is priced massively below its fair value. To fully capitalize, one would want to buy as much of it as their risk tolerance can handle. This is the position size that defines the "maximal long allocation". Opportunities of this magnitude come up fairly often, but how long should one hold this position?
Well, it's not so much a question of when as what triggers the sale. Once the market price appreciates to a certain percent of the target price, we hit the 1st downward slope. While depicted as a straight line, it would theoretically be a curve with the slope decreasing asymptotically as the market price approaches the target price. It is when the market price is on this curve that investors should take profits, selling more and more of their position. As the market price hits the "no touch zone" investors would ideally be selling the last of their shares. ." While these could be phenomenal companies, there is little opportunity in the stock. Consequently I would advise having absolutely no allocation to stocks trading in this range.
A stock trading at its intrinsic value has no room for capital appreciation. Sure a volatility event could push the market price higher, but it would be just as likely to drop. The truth of this statement requires a correct price target. In other words, stocks trading below their price target would be pulled up and those trading above it would be pulled down. It is this force toward proper valuation that establishes the price target. The further a stock's market price deviates from the price target the greater the magnitude of value there is in holding that position. For stocks trading below the target, this value is positive so we want a long position and for those trading above, this value is negative which promotes a short position.
Establishing proper price target is a substantial subject of investment theory. It is highly debated and sufficiently complicated that it falls outside the scope this article. Instead, this discussion is about proper allocation around a given price target.
Continuing from left to right, when a stock's market price hits the 2nd downward slope, holding it begins to have meaningful value. Of course, this value is negative, so it can be unlocked through a short. With only a slight negative value, investors would be wise to take only a small position as the force pulling it to the price target is still rather weak. If this force is overwhelmed by the prevailing market perception and the price rises even higher investors can respond by increasing the size of their short position. Given the inherent risk associated with shorting, I would recommend a fairly conservative maximum short allocation.
If and when the price moves to the price target, investors should begin covering as it hits the right side of the 2nd downward slope and fully cover the position once market price returns to the "no touch zone".