Trailing Stops and Position Sizing: Two Tips to Avoid Letting a Bad Stock Sucker-Punch You
by Louis Basenese, Small Cap and Special Situations Expert
Thursday, October 8, 2009: Issue #1111
I confess… I got it wrong with gold.
Unlike some stock-pickers and newsletter analysts, who proudly trumpet all their winners, while shuffling the losers under the rug, I have no problem admitting when my calls go against me.
And to the delight of all the naysayers, this happened just a couple of days ago when gold prices shot to a record high. That triggered my sell-stop and, rather than let my pride come before a fall and hang on, it’s time to move on.
Don’t get me wrong, though… I’m still convinced that the yellow metal could suffer a correction for three main reasons…
- So far, inflation hasn’t reared its ugly head. If it stays in hiding much longer, disillusioned investors will probably head for the exits.
- If the U.S. economy recovers quicker than expected, investors will be inclined to abandon the safe haven of gold and reinvest in equities.
- The technicals point to a drop. The last four times gold spiked near or above $1,000 per ounce, it quickly (and sometimes precipitously) corrected.
However, giving into these convictions – and doubling down on gold – would mean abandoning two core investing disciplines that I swear by – position sizing and trailing-stops…
Have You Considered Using Trailing Stops & Position Sizing?
I know… you’ve heard about them countless times before. But indulge me for a moment, as I explain an aspect of both trailing stops and position sizing that you’ve probably never considered…
- When I speak at investment conferences, I always like to ask people to share their biggest loser. Heads go down and nary a hand rises.
- Conversely, when I ask them to share their biggest winner, it’s like I just offered free candy to an auditorium full of kindergarteners. Everyone’s hand shoots up and there’s a chorus of anxious, “Oohs!”
Nobody likes to talk about losing investments. Instead, we want to thump our chest over the latest 1,000% gainer. The reason for that is obvious, so let’s focus on the fear about talking about our losers.
Many investors turn their biggest loser into a total loss. Instead of employing a trailing-stop and exiting a trade as the price tumbles, they make it a long-term investment to save face. Or worse, they invest more at lower prices. Most times, the stock goes belly up and they lose even more.
Even the professionals can’t claim immunity here.
- For instance, take Bill Miller, the famous manager of the Legg Mason Value Trust Fund (LMVFX). Although Miller beat the S&P 500 for 15 consecutive years, he refused to man up to his mistakes when the market took a nosedive in 2008. He kept averaging down in stocks like Countrywide, Bear Stearns, Freddie Mac, Merrill Lynch, Washington Mutual and AIG.
- He revealed the true depth of his arrogance when he was asked how he knew when to stop buying a falling stock. “When we can no longer get a quote,” he replied. In other words, the only price at which he was unwilling to buy more was zero.
Here’s my point…
Avoid Losses With A Position Sizing & Trailing Stop Discipline
I’ve always religiously adhered to a 25% trailing-stop discipline and a position size of no more than 4% in any one investment, and I’ve stopped worrying about my losses – since they’re always contained.
The beauty of such a simple, disciplined approach is two-fold…
- The results add up, decidedly on the plus side.
- A trailing-stop and position sizing policy allow me to keep making bold calls without regret. The bolder they are, the smaller my position size.
For instance, for my short gold call, I only invested 2%. For a hypothetical $100,000 portfolio, that means investing $2,000 and losing $500, or less than 1% of the total portfolio value.
Bottom line: I don’t ever let an investment turn into an unacceptable loss. And I never put too many eggs in one basket. Sure I might lose 25% here or 25% there, but when I keep my position sizes small, in the grand scheme of things, it’s no big deal.
Such a strategy leaves me with plenty of capital to re-deploy and keep gunslinging. And while gold didn’t work out, some other contrarian bets are already making up for the loss and then some.
- Take Sotheby’s (NYSE: BID), for example. Back in June, I advised readers to buy shares when everyone else believed the market for investing in fine art was going into a long hibernation. The fundamentals faltered, but they didn’t collapse. As a result, Sotheby’s rallied 68% from my entry point.
- Then there’s my recommendation last Thursday to buy into the beleaguered retail sector with hhgregg (NYSE: HGG). It’s up 5.7% since then.
If I take profits on both now, my misstep by shorting gold doesn’t even matter.
The Critical Component to a Disciplined Investment Approach: Accountability
But of course, a disciplined investment approach is useless without the critical component of accountability… In terms of position sizing, there’s only one person who can keep you honest: Yourself.
But when it comes to implementing trailing-stops, multiple options exist…
- A So-So Option: Enter the stop levels with your broker. However, this is not ideal. Market makers can manipulate prices to trigger these stops.
- A Better Option: Use a service like TradeStops (www.tradestops.com). For a nominal annual fee, it will alert you via text message and/or e-mail when your stocks hit their trailing-stops.
Good investing,
Louis Basenese
Related Investment U Articles:
- Do Trailing Stops Really Work?
- Do Trailing Stops Really Work?
- Investing in Options: An Insurance Policy Against a Volatile Market
- Protecting Stock Profits: Here’s the Breakdown of the Ultimate “Safety Net” Trade
- International Investing: Consider These Four Superpowers
4 Responses to “Trailing Stops and Position Sizing: Two Tips to Avoid Letting a Bad Stock Sucker-Punch You”
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In addition to being the foremost expert on small-cap stocks, Louis is also well versed in special situations including IPOs, mergers and acquisitions, spinoffs and contrarian investments. His commentary has been featured in several media outlets, including MarketWatch. And he's also a top-rated speaker at financial conferences throughout the country. 
Great article ! I do not know who the guy was that advised on the buy of LZB but it was right on!!! As well as about 90% of the other recomondations. Thank you
Eric Dale
Calif.
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On trailing stops, which I agree with, there is another option on how to use them. You can use a broker like OptionsXpress where the system tracks the price of the stock, intraday, and triggers a market order to sell when the trailing stop is hit. This way you don’t have to watch it, or get an e-mail based on end of day price or risk an unscrupulous market maker triggering your stop.
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Great article, Louis. Anyone who says he only has winners is lying and self-deluded. Losses happen to all of us who invest in or trade stocks or any other financial instument. But, as you say, correct position sizing and religious use of trailing stops keeps us always in the game. Keep up the good work!
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how does one calculate trailing stops with stocks that one has purchased for long-term dividend income…
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