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CHAPTER7

EXIT STRATEGIES

It is all too easy to hold a successful position and watch it quickly descend into a

hell of unrealized loss. Unless it’s tax time, and you have taken wonderful gains on the

portfolio, it is undesirable to take the loss—even unrealized. At this point, when you see

the position tanking you wish you might have a plan. Making a plan in the heat of a

tanking position, portfolio, or market is heady for a very small minority of traders. Most

of us want an orderly plan of action which appreciates fight or flight but with the Dalai

Lama’s cool sensibility.

We feel smart when professional investors state that we are good investors; we

buy, we buy more, and more just like they advise us. What we buy is irrelevant as long as

today what we buy is shares of solid companies. Future cracks in the company

fundamentals are nothing to worry about: they are temporary; tomorrow the company

will be stronger.

The stock market as a whole has performed better than the bond market for 40

years, and its average return has been 8%, so what if this year it went down by 30%. If

you hold long enough on your stocks when it is time to cash in you will be laughing to

the bank. Unfortunately, such statement is true only because we are talking about the

market index not the individual stocks within it. If you look at the Dow Jones Index

through time you will be shocked to find out that none of the companies that were in it in

1930, are still in it today. Through time, this index, and the S&P500 have evolved to

represent the players in the current economy. In short, just like the weather, and us, the

market also changes.

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In 1969 there were companies that were called the Nifty-fifty. Nifty-Fifty

contained IBM, Kodak, Polaroid, Avon, Merck, Digital Equipment, and Texas

Instrument. Investment houses promoted aggressively these companies as safe even to

orphans and widows. Investors who, thanks to the influence of the media, held to the

belief that these companies would hold well during a market decline, came in drive and

bought shares in the Nifty Fifty. These companies stock prices appreciated to the point

that they were 80 times their earnings. Unfortunately for investors who kept on this

belief, when the bear market of 1973 and 1974 arrived, the Nifty-Fifty stock price sank

along everything else, and by 1974 they had lost 54% of their value.i

One company that is worth mentioning is Polaroid, the darling during the early

70’s. Polaroid stock price went up to $143.50, and then it started sliding to $100, then to

$90, then to $80, and then to $75.00; during all this time investors in the Nifty Fifty said

that the company cannot go much lower, because good companies always comeback, and

we all know that good companies always comeback. However, in less than a year

Polaroid stock price went from $143.5 to $14.12. In 2001 the company filed for

bankruptcy, and in 2005 Minnesota Entrepreneur Tom Petters bought it for $426 Million.

This is one example where buy and forget strategy will get you in trouble. Some of you

will point out that the world has changed.

The reality it is far from true, Fortune magazine, in its August 2000 issue,

recommended Broadcom, Charles Schwab, Enron, Genentech, Morgan Stanley, Nokia,

Nortel Networks, Oracle, Univision, and Viacom for a buy-and-forget portfolio. We all

know what happened to Enron, but the most astonishing fact is that only Genentech stock

price appreciated within the last six years, August 2000 to 2006, while all others have

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still to reach their 2000 price level. Hence, confirming that buy-and-forget strategy can

also cause you to lose money.

For you or any investor, the most important step to take in investing in particular

company is to change your belief in buy-and-hold myth to “a decision to hold is like a

decision to buy again today—it is reinvestment for another day in the same stock without

paying commissions”ii. You as an equity holders have more to lose than the bankers or

other investors in the company, so you have to set up exit strategies to take a profit from

your position and to protect your investment.

You can think of an exit plan as an insurance against losing all your principle,

and most of your profit. You can also think of it as a pre-nuptial, you love the person

that you are about to marry but you still want to prepare for the eventual break up of the

marriage even if such eventuality never comes up. In short you want to be prepared for

the unexpected, even if the unexpected does not realize.

The problem with exit strategies, or plans is that they have to be in place before

you buy your holdings. If you prepare yourself for an eventual change of your company

direction, when a crisis arises you will be able to act decisively, and in more emotional

control. Most importantly, you will not be following the herd, but you will be following

a rational argument that you had put in place. An investor, just like a daredevil, an

acrobat, or a scuba-diver, needs to be prepared for disasters.

To prepare yourself for a disaster, you need to decide before buying shares what

criteria you will use to exit your position. By answering these questions a-priori you will

be able to create a more coherent investment strategy, and they will force you to be

disciplined while dealing with the market. We tend to be emotionally comer when we

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know what how to deal with that may arise in the future. Even if we may never have to

use them, we buy health, house, car, life insurances not because we know that we need

them but to protect ourselves from a disaster that may or may not happen.

Unfortunately, the stock market every company either becomes too big that its growth

converges to a mediocre return, taken over, or becomes instinct. We are pressed to

answer to the question if we want to succeed as investors.

Exit Criteria

Red Flags and Etc.

If a company fundamentals are deteriorating then one should always sell. You

should look for red flags, mentioned earlier, as an integral part of your exit strategy. You

do not want to hold on a company whose sales are lagging while its receivable, inventory

and liabilities are soaring. You want to hold on a company that gives huge pay and

bonuses to its CEO only for a short-term performance. From 2002 to mid-2006, Home

Depot has given its ex-CEO Bob Nardelli $123.7 million, excluding certain stock option

grants, while it has reduced bonus for employees by almost 50% and its stock price has

been lagging. This shows that the management content of the state of the company, and

lack of creativity in finding new ways to expand the company. This company is good for

a quick trading.

You should also sell if a notorious short-seller is becoming interested in your

company. You can be sure that the company is in trouble if he/she is selling shorts the

stock. Short sellers have a lot to lose if they are wrong in their assessment of the health

of the company. They have the potential of losing more than what they invested in.

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In short, when companies convey too many red flags you should sell regardless of

the company current stock price; selling indiscriminately ones holdings is the right exit

strategy to use—no point holding on a sinking ship even if it has not started to sink yet.

You may decide to wait just a little bit longer to make extra profit; bur then you may find

yourself unprepared when the red flags become apparent to all to see, and the company

starts sinking precipitously. The best example is, of course, Enron: in one month it lost

more than 90% of its market capitalization.

In most cases the news are too late to protect us from a certain loss. If you live in

the East or the West coast you have lived through the fierce price bids among home

buyers in the housing market. You have seen investors flipping houses and making

sustainable profits. By the end of 2006, you have noticed that more and more houses in

your area are staying longer in the market. Houses that used to sell within a week, now

they are taking more than 3 months and in most cases they are not selling. If you have

been following the news, you know that by the end of 2006, economist and media stated

that the housing market will cool down slowly but nothing to worry about at all. As of

the end of 2006, the housing market at the surface look OK, until you start looking at the

major home builders stocks: Toll Brothers (TOL), Lenner (LEN), Centex CP (CTX),

Pulte Homes (PHM).

In July 2005 , Figure 1, these stocks were at their pick, but then they started to

deflate slowly. If you ask us, what caused the deflation to start on that month? We do

not have an answer. We do know that by the end of 2006,our friends and neighbors were

having problems selling their homes, implying that the market was softening ; the extend

of its softening we did know. Until February 2007, we inferred from reading the news,

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and economist discussion about the housing market, that houses price would start to

deflate but in an organized way—no bubble bursting here. Suddenly, in February, 2007

we noticed all these articles about the rapid cooling of the housing market popping in all

major newspapers and even in www.msn.com. Some of them stated that in some

northeaster regions there were too many condos for sell and not enough buyers. They

went on to state that these condos are expected to stay 28 months, that is over 2 years,

before they can be absorbed in the economy

Then there were the articles that new home builders are given extra-ordinary

incentives: pay for one year buyers’ mortgage, or buy the buyers homes, to name a few.

These articles show that the housing market was in some trouble, but to what extend? we

did not know until February 8th, 2007

Figure 1. CTX, LEN, PHM, and TOL Seven years stock price performance

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The news in February 8th, 2007 Wall Street Journal under the title “Toll CEO

Sees Uptick Behind Grim Number” by Janet Morrissey (2A) stating that orders to Toll

Brothers dropped by 33% in its fiscal first quarter confirm that the housing market is in

slump, and these companies stock price have no where to go but down, at least for the

next 3 months. In short, if you are invested in home building companies you should get

out, if you are not invested than do not put money in them. The recovery is far from

soon.

In most cases, most news is just confirmation of events, they are not precursor or

reading of future events, this example is no exception. They are confirmation and

explanation of the phenomena that one has been experiencing for a time but just became

apparent.

News from one company can trigger you to sell in another company. In 2005 we

started seeing these new exotic mortgages called interest only mortgages, and ARM with

teasing extremely low introductory interest rate. We have also seeing proliferation of

subprime mortgage landing. To mitigate their risk, these lenders packaged these loans

and sold them to a third party. In theory, the primary lenders are in a win-win position: if

the borrowers cannot pay, the third parties are the ones that will lose money. Low risk,

high return, this is an investment I want to be in!

But wait a minute, on February 8th, 2007, HSBC, the third largest bank in the

world announced that that its charge, for bad debts would be more than $10.5Billion for

2006, 20% higher than analysts $8.8Billion estimate. HSBC was one of the third parties

we mentioned earlier. The article continues to explain that the reason behind such

unexpected news is that the loan originators provided mortgage loans with no filters in

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place. They did not bother checking the borrowers’ income or job positioniii or

requesting for a down payment. First time in history, it became easier to be a home

owner than a renter; in most markets, renters have to pay a deposit equivalent to 2

months, and they have to have through a credit check. .

Figure 2. FMT, NFI, and NEW Seven-year Stock Price Performance

The article was devastating to all the companies that specialize in sub-prime

mortgages. Investors and traders alike have inferred that these companies would be in a

bigger trouble than HSBC (HBC), most of them will be forced to buy back these loans

that they pre-packaged and sold to other investors, and proceeded to sell their holdings.

New Century Financial Corp. (NEW), company that specializes in subprime

mortgages, lost 36% of its market capitalization. Other companies in the same sector

followed suit; Novastar Financial (NFI), Fremont General (FMT), to name a few, all saw

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their stock price plunge (see Figure 2). Investors and traders were not going to wait for

the quarterly reports to come out to satisfy their suspicion, they preferred to cut their

losses or take their profit now then wait and lose more, or gain less.

The following day, a following article was published in Wall Street Journal

showing how extensive the default rate was among sub-prime borrowers: in 2006, one

out of 5 mortgage loans was a subprime; in 2006 the rate of subprime mortgage loans

with payment 60 or more days late was over 12%.iv A problem in one company revealed

the fragility of other companies. One can never be certain when and where a devastating

news will pop up, one can only prepare for it.

%Short-Interest

In many cases, news is not always easy to quantify, and sometimes that tend to be

too late to be of great use. In the previous chapter, we presented example of investors

selling on what appeared to be good news (Ebay earning announcement), while at the

same time buying on what appeared to be a bad news (LLY earning announcement),

where the news appears to be bad, but in fact was a good news. For an individual

investors trying to swift between a positive and a negative news can be in the least

daunting, and confusing. We believe that we owe you to present a more quantitative

approach to setting up exit strategies. Here we will describe the percentage Short

Interest, %Short-Interest. In case of subprime mortgage lenders you could have noticed

a-priori that some of them were headed for trouble by just looking at the percentage

short-interest indicator. Only companies within NYSE have this monthly indicator.

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The Percentage Short Interest is the product of 100 and the ratio between the

number of shares sold short and the number of shares. An increasing Short Interest

implies a decrease of confidence among investors, while a decreasing Short Interest

implies an increase of confidence among investors. The value of this indicator for a

given company is published in www.BigCharts.com, www.MarketWatch.com,

www.ShortSqueeze.com, or in www.wsj.com. BigCharts provides the charts to

MarketWatch.com, and wsj.com.

As of February 2007, NEW and NFI have their Percentage Short-Interest

(%Short-Interest) equal to 24%, and 35%, respectively. In the case of NFI (Figure 4), the

stock price has increased from 2003 to mid-2004 while the short-interest has kept at a

20% level, a very high level compared to most stocks. When the stock price started

deflating the Short Interest did not go down implying that the company is still over-

valued even after losing two-third of its market capitalization.

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Figure 3. NEW Five-year %Short Interest

NEW Percentage Short-Interest has been very high (Figure 4). Since 2005 it has

been rising steadily from 15% to 24%. Investors at large are less confident in the ability

of the company to perform—more and more shares are sold short.

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Figure 4. NFI Five-year %Short Interest

We have presented only the obvious companies that fundamentals will change

because of the new housing market, others, such as contractor, real estate agencies, and

investors in mortgage-backed securities such as mortgage real-estate investment trusts,

hedge funds are and will also be touched by the deterioration of the housing market.

Analysts Recommendation

While some of these events are hard to quantify and analyze, especially when it is

beyond your expertise, in this case you look at the company credit rating, the analysts or

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investment house recommendation. In the red-flags section we mentioned credit rating

and their utility. You always have to check and read of your company has been

downgraded by a credit rating agency. A downgrade to a default grade always means

that the company is in a financial trouble. Such a downgrade means that the company is

having trouble paying its debts.

Another downgrade that you should keep an eye on is the analysts downgrade,

especially if the downgrade goes from buy to hold. You should always sell your

holdings if analysts have downgraded them to sell. You may decide to ignore such a sign

but it will be at your detriment. Due to the reasons we stated in earlier chapters, analysts

are fast to upgrade but slow to downgrade a company stock.

www.nasdaq.com presents analysts recommendations in simple graphs that you

can easily interpret. In the Analyst Info page you can find not only the average stock

price estimate for the company but also a graph on estimate change, and another on

revision of estimate within last 6 months.

For instance, in the Detailed Estimates Estimated you can infer that 5 analysts

follow NFI, and within the last 6 months, except of one upgrade, analysts have

downgraded the stock. In fact, in the last two months two analysts downgraded the stock.

We also notice that downgrades started over 3 months ago, so we should have jumped

ship 3 months ago, provided that we knew why this company was downgraded. Three

months earlier the analysts saw that NFI is up to a lot of trouble, even though it has not

been apparent to us until lately.

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Detailed Estimates Submitted

Figure 5. 6 month Analysts change in Earning Estimation

The industry condition may change, but at this moment they still look bleak, we

do not expect in the short-term such NEW will be able to get itself out from the mess it

and its like put themselves in.

Momentum (4 Weeks) Quarter End & Fiscal 12/2006 7 of 7 estimates changed

Up:1

Down:6

Figure 6. Number of Downgrades and Upgrades in the 4 months

You can also look at the Momentum (4Weeks) Quarter End & Fiscal graph

(Figure 6). From this simple graph you can tell instantly how many analysts have

downgraded or upgraded to stock. In the case of NEW, except for one, 6 analysts

downgraded the company stock. The large down grade of NEW implies that eventually

the stock will continue to atrophy, and if you are holding it you better exit as soon as

possible.

So an exit strategy can be based on news related to other companies in the same

industry or sector, analysts’ recommendation, % Short-Interest indicator. All these can

be found in the web with little search.

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Expected Appreciation

Another approach to designing an exit strategy is to look at the company fair

value or analysts average estimate and its current stock price. This approach work for

companies that Peter Lynch defines as Steward—well established companies with

“predictable” growth and earnings—and financially healthy.

Home depot (HD) fair value, which you can look it up in Morningstar.com, was

$40.00 in 2004, and, as of September 29, 2006 was $44.00, analysts estimate was $45.00,

but when one looks at its chart (Figure 7), one can see that the price, in the last three

years, have had large swings ranging between $33.00, which is a 25% discount from its

fair value, and $45.00, and small swings between $33.00 and $37.50. The stock price did

not go below $33.00; the stock has a potential to appreciate by 36% if one buys it for

$33.00 and sells it for $45.00. Even at $36.27, the company stock is still attractive; one

has the potential to make 24% gross profit.

9/29/2004 3/30/2005 9/29/2005 3/30/2006 9/29/2006$32.00

$34.00

$36.00

$38.00

$40.00

$42.00

$44.00

HD

Figure 7. HD 2-year Stock Price Chart

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Now, if you bought HD on September, 29th, 2006, at $36.27, stock price at

closing, and set up your exit at or below $32.00, or at $44.00, you will be pleasantly

surprised to find out that as of January 22nd, 2007, less than four month from your buy,

the stock is at $40.05, which is a 10% appreciation from the price you bought it at, and

only 10% from your goal (Figure 8). This approach does not imply that the stock will

get to $45.00 but you hope that it will get close enough that you will make a profit. In

this instance, you used the fair value, and the company stock price to come with a

winning investing strategy.

This strategy is similar to investing in real estate, where a real estate investor

buys a property below its appraisal price, and in turn sell it at or higher price from the

appraisal one. This is a value investing strategy, where you buy a stock below its fair

value, and sell it at or close to its fair value. It is the strategy promoted by Benjamin

Graham, and Fisher.

9/29/2006 10/27/2006 11/25/2006 12/24/2006 1/22/2007$35.00

$37.00

$39.00

$41.00

HD

Figure 8. HD Stock Price from 10/29/2006 to 1/22/2007

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While one can easily create an investment strategy with an entry and an exit for

well established companies, in many cases, such strategy can be useless. Some

companies, although they are worth more than their stock value appears to stay much

below its worth for years and still not catch up. Amgen Inc. is such company. Although

analysts, Morningstar, Standard and Poor stated that the fair value of this company to be

around $84.00, within the year (February 23th, 2006 to 2007) the stocks has stayed much

below its fair value. It reached $77.00 just to finish at $66.23.

Companies with high potential growth will demand justifiably a premium from

their fair value, but one cannot easily quantify it. Investors and traders pushed Google

stock price to $513.00 despite that Morningstar estimated its fair value at $315.00. As of

February 6, 2007, the stock prices came down to $467.00—still a 48% premium from the

fair value of $315.00—if Morningstar fair value calculation is used. The discrepancy

between the observed stock price and the estimated fair price has to do with investors

expecting higher growth than the assumptions underlying the fair price calculation, or

with investors just loving the stock so much that they are blinded by their love—what we

saw during the dot com era. In both cases an exit strategy based on its price movement

can help investors and traders take their profit

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8/19/2004 4/5/2005 11/21/2005 7/8/2006 2/23/200795.96

200.22

304.48

408.74

513.00

R1

S1

R2

Figure 9Google’s Price Movements Since Inception

Trendlines

You should set up the prices at which you are willing to sell before you buy a

stock. To do so you need to analyze the stock price chart to see intermediate patterns,

long term, and daily swings in the stock price. In most cases, companies problems

reflect in their stock price chart before they reflect in their financial reports, making it

crucial for investors to take the time to look at the charts. If you look at the home

builders, and sub-prime lenders stock price charts you will notice that the stocks have

started to deflate before their problems have been revealed to the public.

When no news or red flags are apparent, a company stock chart can give you an

insight on investors and traders perception of the company value. Investors, as a mass,

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that influences the direction of a stock price. As, Donald Cassidi stated so rightly in his

book that a stock price goes up on buying pressure, but it falls on its own weight.

From the company stock price chart you can infer the lowest price investors and

traders where willing to sell, and the highest price they were willing to pay.

Furthermore, you can see by a glance of an eye if the stock has been having large swings

or small swings of price values.

Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1

2004 - 2007

$100.0

$200.0

$300.0

$400.0

$500.0

Goo

gle

Figure 10.Google's Price Chart Since Inception

Just glancing at GOOG’s price chart you can make many inferences (Figure 10).

Since the company inception, August 19th, 2004, its stock price has increased steadily

from $100 to 461.5 (February 9th, 2007), while it reached a high of $509.65 in November

21st, 2006. For you to know whether to sell or buy you can draw trendlines.

Trendlines, as their name implies are lines that help you see intermediate or long-

term trends depending on the time frame you use for the analysis. You draw the lines by

connecting two or more points on a price chart. An upward sloping line that connects

price lows (valleys) indicates potential area of support. A downward sloping line that

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connects price highs (peaks) indicates potential area or resistance. If the price goes

below the support it is an indication for you to sell. For what ever reason, investors and

traders have decided that the stock is overpriced, and they are selling their holding.

Marketwatch.com, wsj.com, and Etrade.com are the few web-sites that let you draw

trendlines on the fly on the stock price charts.

Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1

2004 - 2007

$100.0

$200.0

$300.0

$400.0

$500.0

Goo

gle

R1

S

R2

Figure 11. Drawing Support (S) and Resistants lines on Google Price Chart

As a first example, we are presenting Google. Google, since its inception, has

been trending up (Figure 11). Its support line, S, has still to be broken. So, if you bought

the stock in 2004, you will still be holding it today. In addition to S, you can see that a

decreasing line was drawn, R1, also called the resistance level. R1 became invalid after

October 5th, 2006. The stock price has gone above such R1, making it obsolete. A new

resistance level is forming, R2, and it still has to be broken.

As you see, using the trendlines on Google would have help you keep holding on

the stock, lowering your transaction costs. This is a more efficient approach to set in up

your exit price, than moving averages, which would have provided you a lower return or

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false signals. In the case of GOOG, trendlines helped us find major trends in the stock,

and allowed us to stay longer and have a profitable investment.

From this example, you have noticed that we are following the major trends, that

have been forming over the years. Sometimes, the stock price chart may have no real

long term trend but only levels of high and lows, so in this instance you want to look at a

shorter period, may be one year or less. For this we have the example of Microsoft

(MSFT).

2/26/2002 5/27/2003 8/25/2004 11/24/2005 2/23/2007$20.0

$24.0

$28.0

$32.0

MSF

T

S1

R1

S2

R2

Figure 12. MSFT 5-year price chart

For the last five years, February 2002 to 2007, the stock has been bouncing

between a major range of $22.00 to $32.00, and a minor range between $24.00 and close

to $30.00 (Figure 12). The minor patterns appeared to have a periodicity of one year. In

this instance, you can buy at a price close to the support levels, and sell at the resistance

level, or you can look at the one year price chart.

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6/3/2006 8/30/2006 11/26/2006 2/23/2007

$22.0

$24.0

$26.0

$28.0

$30.0

S1

S2

You can see that what was not so apparent in the previous graph become apparent

in here. A new trend has been appearing since mid July 2006. So you could decide to

buy at that time and sell when the price goes below that support trendline S1. But then

you see another pattern appearing, that become apparent in mid September 2006; for this

you draw another support trendline S2, and decide to buy at $25.60. The slop is steep

enough that you can decide to use it as an indicator when to sell; so when the price goes

below S2, which happens in January 29th, 2007 at the price of $30.34, you sell, and you

make a profit of 20%.

Money Allocated

This exit strategy has nothing to do with the stock price performance; it has to do

with the stock and its relation to the portfolio it is in. You can decide to set up a

percentage of money that each holding can have. For instance, you have 10 stocks, and

the money is equally distributed among them. You can decide to sell if you lose 5% of

your total investment in one stock. So if you have $100,000.00 invested in 10 stocks,

making it $10,000.00 in each stock, then you will sell if any of these stocks lose

$5,000.00, which represent a 50% drop in value. Doing so, you are ignoring the quality

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of the stock you are holding, and the fact that you waited too long to sell. A 50% drop in

a stock requires that stock to increase by 100% just to get it to the level before it sank. In

most cases, that can take a long time or can never happen. You can decide to solve this

problem by thighting up you loss to 2% from your total investment money, and as long

as the stock and the market are not too volatile, such approach will protect most of your

investment.

Another strategy that has no relation to the stock price performance but more to

appease the anxiety of the trader is whether one should sell bit by bit or all their shares

when the stop price is reached. Neither you nor us have a crystal ball or can see the

future, so the best approach is to take your profit, or cut your loss. Some financial

advisers will tell you to buy more when the stock is going south, or to buy incrementally

more as the stock price is going up, and they state the law of average. This strategy will

work only if you have done the background research on the company in question and you

believe that it is in a temporary set backs. The draw back of this strategy is that you may

find yourself never willing to sell and fooling yourself that more profit is on the horizon;

a profit is not a profit until it is realized. If you continue to buy more and more shares of

a company stock as its price is going higher and higher you will be putting more of your

money at risk. On the other hand, if you continue to buy more of a company stock when

its price is diving down you may lose more than you had anticipated.

If you want to have a portfolio that is always balanced, for instance, the money is

equally distributed among your stocks holding, then every so often, once a year for tax

reason, you look at the your stocks holding sell from the ones that have performed very

well and put it on the ones that have performed poorly; hence, mitigating risks. The

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rational behind this, is that if you have a well diversified portfolio, the stocks within it

will move on a different drum. At one time while some of them will be the market

leaders, the others will be the dog, at other times the dogs will be the market leaders

while the market leaders will become the dogs. So selling some of your shares from the

market winners and buying more shares from the market losers is another approach to

mitigate risk.

Another approach, a more technical approach and more time consuming, is to do

a portfolio analysis, where every so often, you redistribute your money among stocks to

make is more profitable for you: Portofolio Management Theory. For an average

individual investors this approach is time consuming. You need to download the

historical prices for all your holdings, and than use any of the numerous portfolio

optimization statistical models such as Markowitz, or Black-Litterman portfolio design.

Expected Percentage Loss and Profit

You may want to think about how much loss can you expect to live with, and

how much profit do you need to get back to make the investment worth it, and how long

do you want to wait for your holdings to be profitable. You can state that you will sell if

your shares reach $20.00 or if after three months the holding the stock, independently of

the stock price.

Time is important in deciding when to sell. Would you like to hold a stock that

takes 3 years to appreciate or 6 months to appreciate? What are you cost of opportunity

if you stay with a stock that is a dog instead of selling it and looking for a better

investment?

25

But where should you put your loss price? You can state that you want to keep

your loss in any stock at 10% from your purchase price. If the stock price dips over 10%

you sell. If the stock price follow your predictions than your stop loss price that you

have stated become absolute, unless you are not interested in taking your profit. So you

have to have your stop loss price follow the most current highest stock price.

2/16/2004 11/5/2004 7/26/2005 4/15/2006

20

30

40

50

60

Buy

at:

27.7

0

Sell

at: $

46.1

4

Figure 13. NEW Price Chart

For instance, you decide to buy NEW, today, September 25th, 2003 for $27.70,

you put your stop loss at $24.93 (Figure 13). The stock price starts climbing up so you

start increasing your stop loss. The stock price reaches a maximum at $51.24, on March

5th, 2004, so you set up the new stop loss becomes $46.14. On April 12th, 2004 the stock

reaches this price, you sell and make 66% profit.

We know, we know you are thinking that if you put your stop loss lower you may

have not gone out of the stock and you could have made even more money. While in this

context it is true, with another stock it may be to your detriment. You can state that if

you put your stop loss at 23% then you would have been able to ride the long wave up

and taken more profit. The problem with setting such a high percentage stop loss is that

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the reward risk ratio is not worth it. Here, you will 8% extra profit, but if you lose at first

try 23%, you will need to make up 37% on a new transaction just to come even—

provided that you are using the same amount of cash.

You must be wondering why we did not use 5%, instead of 10%. NEW is a

volatile stock, it has large swings that do not change the direction of its price. Just

looking at the position of the negative daily returns 95-percentile, and 99-percentile are: -

6.74%, and -12.56%, respectively, we can conclude a 5% daily drop in the stock price is

not uncommon. We will come back to this point later. So, if we put our stop at 5% we

would have surely exited too early, with little profit. We would have exited at $38.47 on

December 10, 2003, with a profit of 39%, much below our 66%.

The ease with which you can decide where to put your stop loss, without regard

to the stock price comes with a price; you may find yourself exiting too early and too

often to make a significant profit, or you ma find yourself taking more risk than you may

need to take.

Returns

Returns of a stock price are the defined as the log of ratio between today price Pt

and yesterday price Pt-1: log(Pt / Pt-1). From the study of the returns you can learn a lot

about the price movement, and you can deduce an exit price. You have to define what an

exit price. If you state that you don’t want to exit as soon as you enter than you can state

that you will not exit if the stock price is within a percentage from the bought price. To

do so, you need to study the stock volatility, also defined as the standard deviation of the

returns given a predetermined period. You can use the volatility not only to see how

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spread are the returns from their mean, but to evaluate how risky a stock is. A stock with

low volatility tends to be less risky than a stock with high volatility.

For instance, if you calculate the volatility of NEW from January 7th, 2002 to

2003 you will find out it is equal to 4.258%--the mean of the returns is equal to 0.26%.

If we assume that data to be normally distributed, we can state that 95% of them lie

within three standard deviations (0.26% +- 1.64*4.26%) which is between -6.72% and

7.24%. So a 6% drop of the stock price from its previous close is very probable with

such stock. So if you set up your stop loss price at 5% below the buy price you are very

likely to exit with a loss.

On the other hand, if you look at GE, you will find out that the mean and

volatility of its returns are 0 and 1.61%, respectively, and 95% of the returns lie between

-2.64% and 2.64%. In this case, a stop loss at 5% will permit you to sell in case of

unexpected news, but hold on the stock long enough to make a profit.

GE is less risky than NEW: GE returns fluctuate less than NEW. You have less

money at risk for a loss if you hold GE rather than NEW. A drop of 5% or more in a

day is unlikely with GE but is very likely with NEW. So volatility can help you detect

risky investment from less risky ones, and design a stop loss to take into consideration

this risk.

Another way of deciding on the stop loss price is divide your data into bocks

(monthly, quarterly, or yearly) and from each block getting the largest negative return.

You assume that the largest negative returns are extreme values that the stock returns ma

have. Here, you want to find out the extreme values that you may encounter if you hold

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such a stock. You can perform a simple summary statistics on this sample: you will

calculate the mean, the variance, the median, the first and the third quantiles.

We have done the calculation for GE and NEW; as you notice the extreme values

are higher for NEW than for GE, even though GE extremes are taken over a quarter

period, while the NEW extremes are taken over a month period. Although both have

similar standard deviation, you can expect to lose on average 3.25% if you hold GE, but

7.82% if you hold NEW. While these returns are extreme values, they are still useful in

deciding if you should hold on, or sell the stock.

GE (quarter)

GOOG (month)

NEW (month)

Number of Observation 21 13 21 1st Quantile -1.71% -2.62% -4.16% Median -2.76% -3.03% -6.31% 3rd Quantile -3.78% -3.94% -8.65% Mean -3.25% -3.37% -7.82% Std 2.1% 1.39 2.55%

If you want to find out what the expected long term loss if you hold the stock, or

what the probability of encountering a loss larger than any loss that you have seen

before, then, among others, you can use the Generalized Extreme Value Distribution

(GEV). Just like the normal distribution, which is the distribution of the block

maximumv,vi,vii. Although the explanation of such distribution is beyond this book, you

can find statistical packages that provide it.

If you assume that within 5 years, you take the quarterly maximum negative

returns, you can model such sample with GEV; this translates into modeling block

maxima data. From such distribution, you can infer the probability that you will see a

29

loss larger than any loss in the past, and the highest loss than you can encounter if you

hold such a stock for a long time.

Using such distribution we arrived at the conclusion that for GOOG there is

2.19% chance that a new record maximum daily negative return will occur next month,

with a long term average loss to be 11.23% and a maximum loss of 41.97%. There is

6.22% chance that new record maximum daily negative return will occur next quarter.

We expect that in long term we should expect an average negative return of 11.99% with

a maximum loss of 41.97%. As for GE, we found out that there is 4.28% probability that

a new record maximum daily negative return will occur in the next quarter, with a long

term average loss to be 23.96% and a maximum loss of 53.92%. The maximum losses

for GE, and GOOG appear to be extremely improbable, but in case of a sudden

improbable negative events can trigger such a sudden drop.

While for an individual investors the knowledge of GEV, or extreme events

theory may be useful its implementation or the acquisition of a statistical package for

such purpose is expensive. We believe that our approach that take the block maximum

can provide a good enough approximation of what you may need to know about extreme

negative returns to make a stop loss decision.

High and Low Stock Price

Instead of using returns or an assigned percentage stop percentage loss, you may

use the stock price high, and lows. Every stock price has an open price, a close price, a

high, and a low price, and a volume. In most cases, the open and close prices are

30

sandwiched between the high and low prices; unless we have gap up or a gap down. As

an investor or trader you can state that if in the most cases the open and close prices are

between the high and low prices, analyzing the percentage drop from the high to the low

price can provide an insight about the movement of the stock in question, and where to

put ones stop loss.

For instance, in NEW, you can also use the median, and the quartiles to decide

when to sell. In NEW, the median is equal to 3.9%. You notice that it is smaller than

the mean. The median is the mid-point of a data sample. It is not sensitive to abnormal

number that can distort the mean. The quartiles for NEW are: 1st quartile, the 25

percentile, is equal to 2.85%, and the 3rd quartile, the 75 percentile, is equal to 5.42%.

As these observations are common ones, we need to put a stop loss that is beyond the 3rd

quartile. We need to have a stop loss at the 3rd quartile plus 3/2 of the difference between

3rd and 1st quartile, meaning at 5.42 + 1.5(5.42-2.85) = 9.28%viii. This result and the

previous result ensure that we do not exit our position prematurely.

If you perform the same analysis on HD, for November 2004, to November 2006,

you will notice within a day the stock price does not more by much. The median is

1.70%, as of the 3rd quartile, which is 2.23%. So stop loss at a point beyond 4.19% or

(2.23 + 1.5(2.23-1.7)) is a reasonable exit strategy.

There are many reasons for using the median, and the quartiles over the mean and

the standard deviation. The main reason is that the median and these quartiles are

resistant to the impact of few large numbers. 25% of the data values can be very large

without influencing the median or these quartiles. The other reason is that you do not

have to assume the distribution of the data. If you assume that the data are normally

31

distributed, which in our case it is not, you will assume that 95% of the data fall within

the mean and plus and minus 1.96 standard deviation.

In this chapter we presented you different exit strategies from qualitative, such as

news, to quantitative, such as, returns, and trendlines. We do believe that the exit

strategies must be thought out thoroughly before you commit to any transaction. The

moment you transact it becomes extremely hard to act when the stock price is not going

your way, and it becomes extremely easy to make mistakes. In the following chapter we

will present real examples of companies and portfolio set up, and how to use the internet

to speed your research.

i Steve Leuthold, In Focus, April ’99, 20, 121 ii Donald L. Cassidy, It’s Not What Stocks You Buy, It’s When You Sell That Counts, Probus Publishing Company, Chicago, 1991, p.86 iii Carrick Mollenkamp, “Faulty Assumptions: In Home-Lending Push, Banks Misjudged Risk,” Wall Street Journal, February 8, 2007, p. A1 iv James R. Hagerty, and Simon, R, “Default Jitters Batter Shares Of Home Lenders,” Wall Street Journal, February 9, 2007, p. A1 v R. Fisher, and Tippett, L, “Limiting Forms of the Frequency Distribution of the Largest or Smallest Member of a Sample,” Proceedings of the Cambridge Philosophical Society, 1928,24, p. 180-190 vi A. J. McNeil, “On Extremes and Crashes,” RISK, January, 1998, p. 99 vii Eric, Zivot, and Wang J., Modeling Financial Time Series With S-Plus, Insightful, Seattle, 2002, p.129-146 viii David C. Hoaglin, Understanding Robust And Exploratory Data Analysis, John Wiley &Sons, Inc., New York, 1983, p. 59-60