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:
- 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.
- 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
Related Investment U Articles:
- Do Trailing Stops Really Work?
- Do Trailing Stops Really Work?
- Investing in Options: An Insurance Policy Against a Volatile Market
- How Traders and Investors Should Play This Market
- International Investing: Consider These Four Superpowers
8 Responses to “Trailing Stops Made Simple…”
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Alexander Green is the Chief Investment Strategist of Investment U. A Wall Street veteran, he has more than 20 years of experience as a research analyst, investment advisor, financial writer and portfolio manager.
Thanks. Great timing & good reminder.
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Great article, good advice! When this topic is revisited, please explore the relationship, if any, between a trailing stop’s percentage and the security’s beta coefficient. Intuitively, more volatile stocks should have larger trailing stops, and less volatile stocks the opposite.
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if I practice sensible position sizing, then does it make sense to place a stop limit/loss limiting order on an initial options trade. I was thinking that if an options position moved against me by 9-11%, then cutting my losses by closing the position makes sense, or does it pay to just trust your position-sizing and accept a full loss (in worst case) on the options trade, and move on. My options trades seem to just get worse if I get down by about 10% on the trade.
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Sam,
Stop limits are always a good idea, whether it is for stocks or options. If a trade shows a strong negative trend, chances are that it will continue on that path instead of miraculously turning around and landing you a profit. The vast majority of the time, you’ll be happy that you placed a stop limit.
Good investing,
Investment U
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Alex, did you mention in this article not to put
a stop order with your broker?
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Sal,
Placing a stop order with your broker is always a good idea.
Thank you,
Investment U
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Dear Mr.Alexander Green,
Thank you for your excellent idea on how to protect our investment.Anyone who follow this advise will never loose the capital invested in securities.
Thanks a lot.
S.RAJARAM
Chennai, India
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I am just starting. I want to know “how” to place a stop limit. This is all new to me. Thank you for your help.
Yours truly,
Linda Fraser
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