Trailing Stop
The Investment U E-Letter: Issue # 250
Tuesday, June 24, 2003
| For more information on this topic, see Issue # 389: Trailing Stops: How I Track Them And How You Should, Too |
Trailing Stop… Getting Out With A Profit
By Dr. Steve Sjuggerud, Chairman, Investment U
“Should I sell XYZ stock? Or should I hang on and hope?”
For some reason, people will take 10% profits. And they’ll also sit on losers in their portfolio for months, watching them continue to fall. This is “limited upside, unlimited downside” investing - an almost guaranteed recipe for failure. Today, let’s cover how to do it rightusing a trailing stop to end up with big profits and small losers
There are only TWO reasons to sell an investment: If the reason you originally invested is no longer there, or if you’ve hit your pre-defined “point of maximum pain” - your trailing stop.
Both concepts are simple. But most people don’t follow either. Let’s consider each:
Your Reason For Being There Is Gone…
If you bought a biotech stock because its wonder drug was going to be approved by the FDA, and it wasn’t approved, then it’s time to sell. If you bought because you liked the CEO, and he left, then it’s time to sell. If you bought for no reason other than because it was super cheap, and now it’s really expensive, then what are you doing still holding it?
Why did you buy? There is nearly always a MAIN reason why you got into an investment. Go back and remember what it was and then ask yourself if it is still there. I bet you’ll be surprised to find how many investments you’re actually holding that you shouldn’t be, by this rule.
The Trailing Stop: Your Point Of Maximum Pain
The biggest killer to a portfolio is a “catastrophic loss.” If a stock falls 90%, it has to rise by 900% to get you back to where you were. You never want to be in this position.
The best rule of thumb I’ve found is to use a 25% trailing stop. That way, you’ll never have a catastrophic loss
I’ve recommended a 25% trailing stop in every newsletter I’ve written, going back seven years. The concept of a “stop” is simple. If a stock you own falls by 25%, you get out, and “stop” your pain. The concept of a “trailing stop” is also simple: As the stock rises, you raise your “stop” point. If you bought a stock at $5, and it goes to $10, then your new trailing stop is $7.50. If it rises to $20 without falling by 25%, then your new trailing stop is $15.
The best example I’ve experienced with this is JDSU in 1999-the stock rose 1,200% before it fell by 25%. We sold with a 900% gain, using our 25% trailing stop. Today the stock is lower than where it began. Simply by using the trailing stop, we pocketed 900% gains instead of losing it all and then some. It sure would have been a crime to lose money on something that you were once up 1,200% on
The Catcalls And Naysayers…
I regularly get emails from readers telling me that 25% is ridiculous “A one-size-fits-all solution can’t possibly the best solution” is what they’re getting at. After all, what’s the magic of 25%?
The only magic of 25% is that it is simple enough that most of my readers will use it (or at the very least, they can’t blame me for their big losses if they don’t use it). One of my maxims is “If you don’t have an exit strategy, you have no strategy at all. And with no strategy, you’ll never make money in the markets” You’ll always be giving back your gains. A 25% trailing stop strategy is a simple exit strategy. That’s all.
But you are right: Some investments are more volatile than others, and of course wider stops and tighter stops would therefore be appropriate in some cases. Consider this rule as a starting point
The 3-To-1 Trailing Stop Rule…
In any investment, my potential REWARD has to be at least three times my potential RISK before I’ll buy. If you don’t use a trailing stop, that means you have 100% at risk. If you follow my rule, then you’d only trade if you were expecting a 300% gain or more, which is a tall order.
I’m fairly certain that most people don’t think about their reward-to-risk ratio like this when they trade. But they should Risking 100% of your money for a reward of 50% is not likely to lead to big profits.
With a 25% trailing stop, you “only” need a 75% gain to keep your 3-to-1 reward-to-risk ratio. If you believe your upside potential is about 45%, then use a 15% trailing stop. If your upside is about 30%, then use a 10% stop. It’s pretty simple. I bet you’d be amazed at how many investments you have that you’re risking 100% on for a 15% expected return-you’re not going to make money this way.
These are all rough rules of thumb. The goal is to get you to sell when you should, instead of holding and hoping. The real goal is to give you a defined exit strategy. That way, you’ll know when to get out systematically, instead of by the seat of your pants.
The seat-of-your-pants method is probably the most common exit strategy, even among pros. All kinds of research goes into buys, but nothing goes into when to sell stock.
I strongly believe that if you never know when you’ll get out, that you don’t really have a plan. And without a plan, you’ll never be able to outperform as an investor.
Good Investing,
Steve
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Today’s IU Cribsheet
- There are only two reasons to sell: 1) Sell when your reason for entering a trade is no longer in existence, or 2) Sell when your point of maximum pain has been hit. Whichever comes first.
- A simple rule of “maximum pain” is the 25% trailing stop. One suggestion for a more advanced trailing stop is the idea of a 3-to-1 reward-to-risk ratio Ask yourself, “What can I really make here?” Then divide it by three. That’s your trailing stop for that position.
Related Articles:
- When To Sell Stock: Here’s The Best Tool For Knowing When To Unload Your Investment
- Trailing Stops: How I Track Them And How You Should, Too
- Trailing Stops Tested: Do Trailing Stops Really Work?
