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Trailing Stops

Research for Online Investors

This article orginally appeared in MarketToday on 12/18/08

When managing your investment account always look for safe investments. No matter how much research you do and great stock market tips you hear in a whisper from a friend at the Christmas Party, sometimes things go bad.

You must constantly evaluate each stock in our portfolio.  If you are like many investors, why do you have a stock in your account that is down 70%? Let us resolve in 2011 to limit losses.  The best way to protect our profits is by using trailing stops.

We may have up to 20 stocks in our long-term portfolio. Each one of these investments is 5% of our total account. We use a trailing stop on each position of 20%. What does this mean? Let us say we buy Microsoft (MSFT) at $20, the trailing stop is $16 (20 X .80). If MSFT closes at $22, we move the trailing stop up to $17.60 (22 X .80). These valuations are based on the closing price.

We DO NOT recommend entering the trailing stop in the computer. Wild daily price swings can take out a trailing stop and then close higher and you will have sold out cheap. In addition, if you enter the stop in the computer, the floor traders will dip the market and take out the stops.   Long term as your valuations increase, the trailing stop will leave enough room for the stock to fluctuate as it increases in value.

In a general market selloff, or bad news on your company only, your long-term profits are protected by selling at 20% off the highs. By limiting each position to 5% of total assets with a 20% trailing stop, you will never lose over 1% of your total investment account on any closed position!

Doesn't that sound a lot better than sitting on losses of 70%, and trying to decide what to do? It is important to conserve our capital and live to fight another day. I cannot imagine the pain, anger, and frustration of the people that lost everything to Bernie Madoff.

We have no one to blame but ourselves, if we do not sell when the selling is good. Sitting on a loser and then waiting for years for it to come back can be like slow death. With a trailing stop discipline, you protect much of the profit you have in your account and reload when the market allows you to make another safe investment.

Let's look at MSFT again.  MSFT closed at 37.06 on 11/01/07. The trailing stop on MSFT should have been $29.65 (37.06 X .8). I would have set an alert in my trading platform for a close at this level. The stock closed at 29.07 on Feb. 5, 2008, and we sell the stock the next day at open.

This price would have protected much of the gain on this stock if you had bought it at almost any time in the previous five years. I would also point out MSFT closed today at $19.30. You could have rode it down to a 48% loss, rather than booking your gain and looked for another great stock for the future.

You may ask, "Must I watch the screen all day to sell since I am not supposed to enter the stop loss in my computer"? The answer is No. We only need to check the closing price daily. This is to adjust the stop loss price up if we have set a new high, and to check if the price has fallen below our trailing stop. Remember, the trailing stop is based on the closing price. If the stock closed lower than the trailing stop, enter an order to sell the next day.

If I have to enter the sell order and leave before the market opens, I like to use limit orders set at the previous days closing price.  Market orders entered on the opening bell can be volatile. A limit order set at the closing price will almost always fill.  If the market gaps up you will get the higher price on the bell, your limit order set a minimum sell price.  Except for a gap down situation, the market will always cross the closing price from the day before.

Unless you are facing a situation where your stock is broken and being sold off like a broken down nag mule, don't enter a market order. You can use market orders if entered after the open. A companion rule is never buy a stock we have been stopped out of for a few months. A stock that has been a treasured asset in the past does not automatically qualify for future investment potential. Waiting few months allows us to come back to the company with a fresh outlook.

John

WARNING:    The information presented in this newsletter is based on generally available news releases, corporate filings, current events, interviews and the editor's opinions. It may contain errors and you should not make investment decisions based solely on what you believe you have read here. Do your own research, it is your money. If you lose it, it is your responsibility, not ours or your grandmothers! The editor may or may not have a position in any securities discussed. The editor may have held a position in a security earlier, or in the future.

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