Using Trailing Stops

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Using Trailing Stops: The True Art of Selling Stocks

by Alexander Green, Chairman, Investment U
Investment Director, The Oxford Club
Thursday, August 7, 2008: Issue #834

So far this week – and so far this year – we’ve seen incredible volatility in the stock market.

Whenever a stock in our Oxford Trading Portfolio pulls back 25% from its closing high – or from our original entry point – we issue an alert advising members to sell the stock at market.

Why do we depend on using trailing stops? Because they keep us from selling our stocks while they’re in a major uptrend – and prevent small losses from becoming unacceptable losses.

It’s true that many of these are great companies that will bounce back eventually. But “eventually” can be a long time. Our policy is not to argue with the market.

We buy based primarily on the near-term business prospects for our recommended companies. But we understand, too, that changes in fundamentals are immediately reflected in share prices. So that’s where we base our sell decisions.

Adhere To Your Trailing Stops, No Exceptions!

If we don’t adhere to our trailing stops and start making exceptions, our system will break down. And then – like so many investors – we’ll simply be flying by the seat of our pants, hoping our stocks will continue to rise… or stop falling.

I know some members object, especially if they have faith in a company…

But you can’t bank on size and strength. Enron was the seventh-largest company in the United States.
You can’t always depend on quality, either. At one time, WorldCom had the most impressive array of telecom assets on the planet.
Nor will longevity protect you. Montgomery Ward was profitable for 100 years before declaring bankruptcy.

However, if time passes and we recognize that we stopped out of a company due primarily to market volatility and not business fundamentals, we will often recommend the stock again.

Using Trailing Stops – The True Art of Knowing When To Sell

But it’s important to have a sell discipline and stick with it. Using trailing stops and knowing when to sell a stock is the true art of investing… Anyone can buy a stock.

In a study recently 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 did not allow leeway for hanging on to stocks for emotional reasons. The managers who relied on “flexible” sell strategies did far worse.

That’s unsurprising, really. When institutional investors see a stock moving against them, they are just as likely to rationalize as individual investors. And the culprit is always the same: pride, ego or emotion.

Trailing Stops – A Non-Emotional Sell Strategy

As Greg Forsythe, Director of the equity model development team at Charles Schwab, said recently, “Without any kind of sell strategy [e.g. trailing stops], emotions come into play. And emotions are almost always wrong.”

We recognize that our timing will never be perfect. (No investment system devised will ever beat the uncanny accuracy of hindsight.)

But, in our view, market prices generally reflect the prospects for a business better than “expert opinions.”

Using trailing stops protects both your profits and your principal. Not only by taking the emotion out of the investment process, but by basing your sell decisions on the realities of the market.

That can’t help but make you a more successful investor.

Good Investing,

Alex

Editor’s Note: This strict money management rule allowed Oxford Club members to lock in a 62% gain Tuesday on the MSCI Japan Fund (AMEX: EWJ). Learn more on trailing stops - and how to set them up, in Investment U Issue #803, Trailing Stops: Lock In Your Profits with This Not-So-Secret Sell Strategy.

Today’s Investment U Crib Sheet – Making The Most of Trailing Stops

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2 Responses to “Using Trailing Stops: The True Art of Selling Stocks”

Salim Vasani Says:
May 7th, 2009 at 2:07 pm
Thanks for the excellent article. I sell almost all my stocks using trailing stops (except OTC stocks as my broker won’t allow trailing stops on OTC stocks). I look at the historical prices to see the volatility and decide the trail percentage.

Many of the stocks that get triggered using the trail do continue going upward; but then that’s something I couldn’t have predicted. Most of my trails are 10% and 5% if the stock has seen a good rally. I will take advice from this article and try a trail of 25%.

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Dennis Fergus Says:
May 15th, 2009 at 12:03 am
For Investment Project

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