Like position sizing, "sell" rules are one of the most underrated, ignored and overlooked areas of investing. You can find nearly anyone giving their opinion on whether to buy this stock or that stock. But when it comes to actually selling a position, you'll often hear nothing but radio silence from the pundits.
When they do discuss selling a stock, it's invariably on the "next rally" so they can get out at a better price and cut down on their losses. Usually, this is said as the stock continues to plummet.
Van Tharp -- a trading psychologist who's studied and modeled world-class traders like Ed Seykota -- believes exits are even more important than entries.
Tharp's research, along with trader Chuck LeBeau, determined that exits have even more importance than position sizing on performance. Position sizing can amplify a system's return and drawdown, and even modulate its volatility, but it cannot turn a losing system into a winning one.
In his book, "Trade Your Way to Financial Freedom," Tharp created a system with randomized portfolio entries and a defined set of rules that told him when to sell. And it was profitable.
Think about that. The buys were totally random, but his system still managed to be profitable. All thanks to the sell rules.
I've detailed the stock selection process for my Alpha Trader system before. It relies on a proprietary indicator called the Alpha Score, which ranks all stocks based on relative strength (RS) and a key fundamental factor. (For more on how the Alpha Score works, read this article.) Today, I want to talk about my exit strategy, which is defined by two rules.
The first rule comes from one of the indicators I just mentioned: relative strength. RS is a quantitative measure of trend, and when that number falls below 70, the trend is headed in the wrong direction and we sell -- no questions asked.
Our second sell rule is a 25% drop in price from the stock's six-month high. This gives winning positions plenty of room to vacillate within their primary uptrend while also acting as a hard stop to lock in profits on big winning positions.
These two rules have proven reliable. Many stocks have come completely undone after triggering them.
One example is Glu Mobile (Nasdaq: GLUU), which we sold this summer. After the system's sell recommendation, the company cut its earnings guidance by more than half as new mobile games failed to meet expectations. Shares are down almost 42% since we exited the position.
Biotech firm Valeant Pharmaceuticals (NYSE: VRX) is another example. The stock collapsed another 48% after I told subscribers to sell. Accounting irregularities and political backlash against high-priced drugs sent investors rushing for the exits.
Then there is Aluminum Corp of China (NYSE: ACH). It also tanked 46% after it triggered our sell rules, as the economic slowdown in China and secular bear market in commodities took their toll.
Even though selling sometimes feels bad, our sell rules provide a critical function -- they protect us from further and potentially devastating losses.
Sell rules are one of the most important components of a profitable system. They help us adhere to the key tenet of profitable investing: Keep losses small, manageable and from growing out of control.
Our exit rules also help us free up cash for new Alpha Trader leaders. As I mentioned before, Alpha Trader relies on a stock-ranking system known as the Alpha Score. It is the most accurate indicator in our company's history and has tagged over 100 winners in just two years -- with gains of up to 242%.
In fact, the Alpha Score spotted many of the best-performing stocks of 2015. Throughout the year, it tagged leaders that delivered gains of 55%, 60% and 88%.
Now, it's pegged 10 new picks for 2016. They're boasting some of the highest score we've seen to date.
This article was originally published on ProfitableTrading.com: 2 Simple Rules Help Avoid Portfolio Disasters