2 simple rules to double your money and know when to exit trade

The first rule to make money in stocks is you must protect the money you have. Live to invest another day by following this simple rule:

Always sell a stock if it falls 7-8% below what you paid for it. This basic principle helps you cap your potential downside. And, it is the simplest way to make sure you never let a small loss become a ‘BIG’ one.

Why 7-8%?

The next question would be – why just 7-8%? The 7-8% sell rule is based on an ongoing study covering over 130 years of stock market history.

Even the best stock will sometimes breakout and then drop slightly below their ideal buy-point. When they do, they typically do not fall more than 8% or below it.

If your stock does decline more than 8 percent, it usually means something is wrong with your chosen entry point, the company, its industry, the general market, or all of the above.

Even if you sell at an 8 percent loss and the stock quickly rebounds, it does not mean you made the wrong decision. You were protecting your portfolio.

Taking a small loss from time to time is like paying an insurance premium to make sure you do not suffer a devastating hit. And, you can always buy the stock back if it shows strength again.

In a particular week or a volatile market environment, you may choose to limit your loss, say, at 3-5 percent. Your stocks do not operate in a vacuum.

The trend of the overall market has a significant pull on virtually all stocks. That is why it is critical to always view your stocks within the context of the general market.

Are we in the early or later stages of a bull market cycle? Is the uptrend starting to weaken and show signs of rolling over into a correction (i.e., a Downtrend)?

You don't need to hit home runs to win the investing game. Focus on getting base hits. To grow your portfolio substantially, take most gains in the 20-25% range.

Though contrary to human nature, the best way to sell a stock is while it is on the way up, still advancing, and looking strong to everyone.

As William J. O'Neil says, "The secret is to hop off the elevator on one of the floors on the way up and not ride it back down again."

So, after a significant advance of 20-25%, sell into strength. When you sell like this, you won't be caught in heart-rending 20-40% corrections that can hit market leaders.

The Rule of 72:

This simple calculation shows how effective following the 20-25% profit-taking rule can be.

Here's how it works: Take the percentage gain you have in the stock.

Divide 72 by that number. The answer tells you how many times you have to compound that gain to double your money. If you get three 24 percent gains — and re-invest your profits each time — you will nearly double your money.

It is much easier to get three 20-25% gains out of different stocks than it is to get 100% profit out of one stock. Those smaller gains still lead to big overall profits.

An Exception to Taking Profits at 20-25%

If your stock gains over 20 percent from the ideal buy point within 3 weeks of a proper breakout, hold it for at least eight weeks (The week of the breakout counts as Week One).

If a stock has the power to jump over 20 percent very quickly out of a proper base, it could have what it takes to become a huge market winner. The eight-week hold rule helps you identify such stocks, and helps you sit tight so you can reap potential rewards.

Once the eight weeks from the original buy point have passed, you can sell to lock in your gains or continue to hold.

If you have a solid gain, and the chart action and general market are still strong, you may want to sit tight and see how the story plays out. It could be a stock that goes on to even bigger gains.

Example:

In the PNB Housing Finance chart, you can see that it rose 3 percent after the breakout, but the stock fell after that. If you followed the sell rules and came out of the stock at 7-8 percent loss (1), you could have saved your capital from a crash (2).

In the Graphite India chart, you can see that it went up 40 percent in three weeks after the breakout, hitting power to pivot (1). After that, it became a huge market winner (2).

The author is Director of Research at William O'Neil India.

Disclaimer: The views and investment tips expressed by investment experts on Moneycontrol are their own and not that of the website or its management. Moneycontrol advises users to check with certified experts before taking any investment decisions.