As I write this, I’m sitting on a stock that is up over 300% in the past 8 months. It has ballooned significantly as a percentage of my portfolio and is now creating a bit of a conundrum: do I sell it or hold?

I have thousands of dollars of profit sitting there, just waiting for me to cash out. My mind goes back and forth between two positions:

Sell now because:

• New competitors are coming into the market
• Too much business comes from other countries and their currencies are weakening
• It has simply appreciated too quickly and is due for a correction

Hold on because:

• This is a great company and it’s only getting started
• The original investment thesis remains intact
• It has great momentum that’s likely to continue

And on and on I could go in my head — back and forth letting fear, uncertainty, and doubt keep me up at night, and this is a winning trade!

Praise the Lord I’m a systematic trader.

I have rules that tell me what to do in these situations. In this case, I’m following a strong trend. My system alerted me of a signal, I bought it, and I’m holding on until my system tells me to sell.

I don’t have to watch the news to see if this company is making a shift in its strategy to enter new markets. I don’t need to see how their latest investments are going, who their newest board members are, or what the last quarterly report said about their earnings or balance sheet. I can just ride the price and let that distill all of this information down into a single signal.

Profit Targets, Stops, and Reversals

Systematic traders have a variety of methods and tools for creating rules to exit a position. The key is, once these rules are in place, you stick to them and don’t violate them.

Profit Targets

A lot of traders get started with specific profit targets in mind. Basically, if an investment hits a certain return (e.g. 25%) they sell. Some strategies more or less require this, such as many mean reversion strategies. For those, you know what the mean you’re looking to return to is, so you put on the trade and wait for that level to be hit before you sell. Those levels may move a bit in the meantime, so you can put in a profit target as well to make sure you exit in a timely fashion.

This can also be used in highly volatile markets to capture strong, one-off moves.

Keep in mind that profit targets may cap your returns if you’re running a trend-following strategy. You never know where the trend is going to end, it could run 10% higher, 50%, 100% or more, and taking a profit early via a target could severely limit your upside.

Stop Loss and Trailing Stop Loss

If you’ve read any of Jack Schwager’s excellent Market Wizards books, you’ll know how important trading with a stop is. Nearly every super-star trader discusses their learning curve as they made mistakes early on by trading without a stop in place and took a big loss, now they never trade without one.

We don’t want to hit our stops, but this is a clear indicator to sell when a trade has gone against you. Despite this negative connotation, trailing stops can be used to take profits as well. Say you place a trailing stop that moves up with the price of the equity and always stays 10% behind the close. If a stock moves from $10 to$15, then your stop moves from $9 to$13.50, meaning you have an order in place to lock in a 35% profit if the price moves against you.

Reversals and Other Indicators

Apart from stops to bail quickly with small losses after entering a trade, I like to use other indicators to signal when I should sell.

For example, say I’m using a system that buys on a simple moving average crossover. This simple system buys when the 50-day SMA is above the 200-day SMA. I would set a stop loss below my entry point for safety, and I would also have a signal that would look for the inverse of my buy rule, i.e. the 50-day SMA is below the 200-day SMA.

“When you have a position, you put it on for a reason, and you’ve got to keep it until the reason no longer exists. Don’t take profits just for the sake of taking profits.” Richard Dennis

The thinking behind this is that now, I no longer have a positive reason to be long this stock, so I better get out of the position. This same logic can be applied to just about any other entry signal out there. Once that signal vanishes, you can close out the position.

Rebalancing

Apart from all out liquidation, you can design a system that will periodically rebalance your portfolio when things get out of alignment. This helps to control risk and allows you to take some profits off the table from time to time.

Imagine you have $1,000 and purchased the following portfolio on January 1: You have your system set up to re-balance every 6 months, and you check back in then to see a variety of price movements: You’re up over 18%, primarily on the incredible performance of Stock D! You’ll see that you began with an equally-weighted portfolio where each stock got 20% of your$1,000 (or as close to that as possible). 6 months later, your big winner has grown to take up nearly 32% of your portfolio, while a dip in Stock A has seen it drop to 13.5%. Even Stock E, which grabbed you a healthy 13% return is now a slightly smaller overall portion of your portfolio as well.

If you were to re-balance your portfolio back to its original, equal weighting, you’d end up with something like:

This means you’ve sold off a lot of your exposure to Stock D and increased exposure to Stock A (assuming your system is still telling you to be in all of these positions).

Even a simple, equal-weighting re-balancing can be powerful because you simply don’t know where your returns are going to come from.

Take this analysis comparing the SPY ETF with the RSP ETF. If you’re not familiar with these, the SPY mirrors the market-cap weighting of the S&P 500, meaning that you get a heavily unbalanced portfolio by buying the SPY as shown below.

In contrast, the RSP is an equally-weighted ETF; each of the 500 securities in the S&P 500 receive 1/500th of every dollar invested in it. In the final analysis, the RSP outperformed the SPY with 13.37% annual returns versus 7.53% from 2004–2020. The only difference between the two was the weighting and rebalancing of one versus the other.

If you’re living off of your investments, this regular rebalancing is a good way to pay yourself by bringing your portfolio back to its target size. Large quant firms like Renaissance Technologies do this exact thing — they return money to investors every year for income and to ensure they don’t grow too large and reduce the effectiveness of their strategies.

When are you going to make your money?

No matter how you do it, it’s important to have rules to follow that will tell you when to close out positions and take your profits (or losses before they grow). No system is going to nail the top consistently, so don’t worry about that. What’s important is to remain disciplined and follow a well-developed strategy. This will keep from making emotional decisions with your money, decisions which have a nasty habit of leading to large losses.

However you do decide to get out of a trade, make sure that your approach is consistent with your overall strategy. A trend following strategy shouldn’t use profit targets, for example, unless you want to limit your returns. The best way to develop a strategy and set these values is through a well-constructed backtest.

At Raposa, we are building a platform to enable you to build your own systematic strategy, backtest it, and deploy it. We want to remove the FUD from retail investing with solid risk management principles and reliable systems that you can count on day after day.