Do Trailing Stops Really Work?
by Alexander Green, Chief Investment Strategist
Monday, June 14, 2010: Issue #1280
Somebody recently told me over lunch that one of the most controversial aspects of our investment policy is trailing stops.
But they shouldn’t be.
If you don’t have a premeditated sell discipline – and the vast majority of investors don’t – you’re flying by the seat of your pants. And that rarely leads to superior investment performance.
But do trailing stops really work?
Survey Says: Use Trailing Stops
In a word: Yes. Trailing stops protect your profits and your trading capital. And there’s much more than just anecdotal evidence.
In a study published in The Journal of Portfolio Management, Christophe Faugere, Hany A. Shawky and David M. Smith – finance professors at the State University of New York at Albany – researched the performance of money managers who oversee pension funds, endowments and high-net-worth accounts.
Because most institutions work under strict investment guidelines, these academics were able to analyze performance based on differing approaches to selling stocks.
The result? Institutional managers who fared best were those with restrictive rules that didn’t allow much leeway for holding stocks for emotional reasons. Managers who relied on “flexible” sell strategies did far worse.
Count me as unsurprised. Institutional money managers are just as prone to rationalizing as individual investors when they make a mistake. (Hence the old Wall Street chestnut, “What does a broker call a trade gone wrong? A long-term investment.”)
Trailing Stops: Providing Protection… Securing Profits
The culprit is almost always pride, ego, or emotion. Without any kind of sell strategy, emotions come into play. And emotions are almost always wrong.
But by adhering to a disciplined trailing stop strategy, our investment system mows down emotion-driven trading errors like a field full of dandelions.
It cures greed. Eliminates fear. And does away with wishful thinking – as in, “I hope this stock turns around and starts going the right way.”
Of course, trailing stops aren’t the only sell discipline out there. But they’re one of the easiest to implement. They serve two purposes…
- They make sure we never let a small loss become an unacceptable loss.
- They keep us from selling stocks while they’re still trending up.
Maneuver Past the Market Makers With TradeStops.com
The one knock against using trailing stops is that unscrupulous market makers will sometimes take out your stop order right before a stock takes off.
But Richard Smith, President and Founder of TradeStops.com – and a PhD in mathematics – has a service that provides an ingenious solution.
If you visit www.tradestops.com, you can enter the stocks you own, the price you paid and the percentage trailing stop you want to use. There are several valuable benefits…
- If any of your stocks close beneath your selected stop, TradeStops sends a message – to your cell phone, e-mail, or account page – alerting you.
- Some brokerage firms, like Fidelity, offer trailing stop alerts with their accounts. But they generally expire after 30 or 60 days. TradeStops information never expires and even offers a 30-day risk-free trial.
- You can track up to 50 stocks at a time. (And whenever you stop out of one, you can replace it with another.)
- TradeStops is easy to use. It’s specifically designed for technophobes.
- It’s reasonably priced. Ordinarily, the cost is $7.95 a month or $79.50 a year. There are additional services available for dedicated short-term traders who want even more.
- It’s important to note that TradeStops notifies you of stops, not your broker. And it doesn’t enter sell orders. But the key is to make sure you have an acknowledged point where you’d be willing to sell any individual stock.
Trailing stops don’t just offer to cut your losses and protect your profits. They guarantee it.
Good investing,
Alexander Green
Related Investment U Articles:
- Do Trailing Stops Really Work?
- How Traders and Investors Should Play This Market
- A Solid Investment Strategy For a Shaky Market
- Protect Your Silver Profits Now
- Investing in Options: An Insurance Policy Against a Volatile Market
12 Responses to “Do Trailing Stops Really Work?”
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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.
It’s ironic to me that today’s column on trailing stops is followed by a promotion for Lee Lowell’s IMT letter which does not advocate or use them.
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Regarding your trailing stops, I agree but have two variations on the theme – which havn’t bitten me yet:
1. Keep stops to your self versus placing a broker order – it is too easy for a trader in today’s volitility to go down and pick up stock cheap when it is really heading higher, and
2. If you think you know why a stock is going temporarily lower but is strong, make an educated choice [such as an insider giveaway (in my opinion)where a new, small private placement of public stock is given price preference - check out Atlas Pipeline APL whose price was driven into low $6 range from $8 some months ago; it then recovered and went higher in a couple of months].
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You can leave the order with your personal call on the phone broker, you just do not want to have them place the order with the floor traders. Otherwise as you say they may run the stops and take you out, just before going higher.
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Then why were there none on the Perpetual Income Portfolio which would have protected capital during the crash? Stops are correct and I was foolish enough not to set my own on that portfolio since the club advice was to have no trailing stops.
You should “eat your own cooking everywhere” if you are to be believed.
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I CAN SEE THE ADVANTAGES USING TRAILING STOP LOSS
HOWEVER I HAVE DIFFICULTY UNDERSTANDING ITS RATIONAL. IF YOU ARE STOPPED OUT SOMEBODY HAS BOUGHT IN. IS HE THEN MAKING A MISTAKE IN BUYING THE STOCK ? IF NOT AREN’T YOU MAKING THE MISTAKE IN SELLING JUST BECAUSE THE STOCK HAS HIT YOUR TRAILING STOP LOSS POINT ? SHOULDN’T YOU BE SELLING BASED ON YOUR ASSESSMENT OF THE VALUE OF THE STOCK GOING FORWARD RATHER THAN BECAUSE THE STOCK HAS HIT YOUR TRAILING LOSS !!
KP TONG
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KP if you make a judgement as to where support is. What constitutes an uptrend. Then when prices close below your support. It is a sign to you that the trend has changed. If the trend has changed you may want to get out. The stop alerts you to the change in trend as you see it.
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Trailing stops did not work on may 6th(the flash crash) and they generally don’t work in volatile markets. They are great when the market is trending up like last year and in the February to April time frame, but there is a new sheriff in town and his name is extreme volatility. If you keep them too tight you get whipsawed and stopped out. If they are too loose you can lose 20% on a trade.
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Losing 20% on a trade is no big deal. If you get stopped out down 20%. You only need to gain 25% to get even. But if you drawdown 50%, you will need 100% to get even. Twenty percent is better.
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I just ordered the trailing stops for the year. I did put that Oxford was where I heard about it, but they took my AMex number and didn’t say how much they charged. Did I get the 39.99 or the regular price?
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My broker offers “alerts,” one of which is, “send me an email if the price of XYZ drops below $x.yy”
I must manually update the amounts when a stock goes up, but that’s not too difficult to do.
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I often use trailing stops in my practice. It’s really great strategy!
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The Peter Lynch idea that a stop loss order guarantees a loss is overly simplistic. It can also snag a profit.
Case in point: Last night I placed a 1% trailing stop order on a rising security. This morning the security “popped” 3%, then gave back 1%, triggering my order.
I call this a hook, and I made a 2% profit that I otherwise would have missed. I now am able to reinvest the cash wherever I want, including the original security.
Hooks happen a lot in this volatile market.
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