Trailing Stops Made Simple…

by Alexander Green, Chief Investment Strategist
Monday, November 16, 2009: Issue #1138

Everyone likes to talk about stock market winners. No one likes to talk about losers. Perhaps especially those of us who pick stocks for a living. But buy enough stocks and you’re bound to have some losers. And that’s okay.

Intelligent investing is about managing risk, not running from it. Avoid volatility altogether with money markets and T-bills and you risk not meeting your investment goals. Turn a blind eye to volatility, on the other hand, and your portfolio will give you a kick in the pants.

The solution is two-fold:

  1. Understand that taking risks inevitably means some investments won’t pan out. Recognize this and you’re far less likely to run to cash, or throw in the towel on a practical, long-term strategy.
  2. Cut your losses and let your profits run.

You do this by running a trailing-stop behind each individual stock position, let me explain…

Where to Place Your Trailing Stops

How far behind should you place the trailing stop?

  • For longer-term investors, 25% is about right.
  • For short-term traders, 15% is closer to ideal.

Why the difference? Running trailing stops is an art, not a science. Your goal is to run the trailing stop as close as you can without getting knocked out by a stock’s day-to-day, or week-to-week volatility.

Short-term traders are looking to nip a lot of smaller gains. Longer-term investors – partly to avoid short-term capital gains taxes – prefer to place a trailing stop where they’re likely to hold their stocks longer and perhaps score even bigger gains down the road.

The system is straightforward…

Trailing-Stops Made Simple

Let’s say you get filled at $20 a share. If you’re using a 25% trailing-stop, place a sell-stop at $15. If the stock moves up to $30, your sell-stop should be moved to $22.50. And so on. This protects your profits.

And please don’t tell me you don’t have time to adjust your stops. If you can’t watch your portfolio, you really shouldn’t be trading individual stocks.

If you’re busy, however, one solution is Tradestops.com. The service sends you a text message – to your cell phone or e-mail account – alerting you any time one of your stocks closes below your selected stop. (Visit www.Tradestops.com for details.)

But trailing stops don’t just protect your profits. They also protect your principal. This is equally important.

Protect Your Principal With A Trailing Stop Discipline

You never want to let a small loss turn into an acceptable loss.

For example, if you take a 20% loss on a stock, you only need a 25% gain to be made whole again. However, if you let a stock drop 50% before selling it, you need to earn a 100% gain to restore your capital.

And if you’re even less disciplined in cutting your losses and you let a stock fall 75% before selling it, you need a 300% return on the proceeds to get back to your starting point. That’s not easy.

In short, don’t fall in love with your stocks. They won’t love you back. Our motto is this: Marry your sweetheart, not your stocks.

Using a trailing stop provides a discipline. It may sound cliché when I tell you that you need to cut your losses and let your profits run. But there’s a reason for it.

It’s true.

Good investing,

Alexander Green

Editor’s Note: In the end, much of what it takes to become a successful investor comes down to knowing the best times to buy and sell. Some investors rely on technical analysis; others pinpoint fundamentals. But regardless of the methods you use, it’s pointless if you don’t adequately protect yourself from a volatile, unforgiving market. Using trailing stops and position sizing are core investment practices at The Oxford Club, but if you want to take all the guesswork out of the process and let some of the best, most successful analysts do the work for you, then consider becoming a member. Just check out the many benefits you’ll get – and all for just $79 a year.