Trailing Stops

Trailing Stops: Lock In Your Profits with This Not-So-Secret Sell Strategy

by Floyd G. Brown, Advisory Panelist, Investment U
Wednesday, June 04, 2008: Issue #803

Everyone’s got a story about a stock they wish they had sold. For contrarian investors, selling is a difficult task. We pride ourselves on holding stocks for the long run. But the truth is, you have to know when to take profits… and when to cut your losses, using trailing stops can help.

During an extended bull market like the one we have seen in oil, it is important to exercise caution in this particular sector. We’ve been riding this wave nearly eight years. I know all of the reasons oil should continue to climb, but I am not a market timer. I bought oil stocks in the late 1990s because they were undervalued by a series of metrics. But now they are becoming overvalued.

Many investors have credited the dollar’s protracted decline against the euro and other foreign currencies as the key reason for oil’s rise. These investors are betting that oil is a hedge against inflation, and it has been.

But regardless of whether you’re investing in oil stocks, currencies, bonds or commodities, knowing when to sell is just as important as knowing when to buy. We have developed a trailing stop strategy that can help make those decisions much easier…

Determining An Effective Trailing Stop Strategy

It makes more sense to have an effective trailing stops strategy for determining whether to sell a stock or stay in it. You may want to consider the following methods:

First, set trailing stops. If one of your stocks has had a nice run and it retreats back to your trailing stop, liquidate it from your portfolio. This will keep you from retracing your steps too far after the high.

Second, adjust your trailing stops higher for stocks you feel have had a tremendous run or that seem excessively high for their value. Raising your trailing stops helps you capture more of the gains should they decline. Note: Adjusting trailing stops is a matter of preference. The closer you set the stop to the current price, the more likely it will be triggered in market volatility.

Third, look for overvalued firms that have gotten too expensive compared to their growth and earnings. With natural gas and oil soaring, some of these stocks now have PEs more than 30 times estimated earnings. Look at the balance sheets and adjust firms with too much debt. High debt tells us it is time to reset our trailing stops closer to the current price.

Adjust Trailing Stops To Lock In Gains

At these lofty prices you may consider adjusting your trailing stops to lock in gains. It never hurts to take a profit. I recommend holding long-term positions in oil and natural gas equities.

When (or if) energy prices pull back, you can consider adding to positions in the most undervalued companies in the sector. By buying undervalued companies in a hot sector, you will increase your margin of safety even as you enjoy the long-term trend up.

I’d consider waiting for a period of price weakness before adding to positions in the energy sector.

Inflation (too much money supply from the Federal Reserve) is the driver of the price of oil and natural gas, not fundamentals. After a correction, oil and gas will continue their upward march. Over the long term, the U.S. Government cannot continue destroying the value of its currency.

No commodity, no stock, no trend continues without occasional weakness. If you know when to sell a stock, you’ll take less of a hit… and you’ll keep more of the gains.

Good investing,

Floyd

Floyd Brown, a regular contributor to Investment U, began his highly successful investing career while still in high school… making his first million before turning 30. Floyd is a regular contributor to The Oxford Club, as well. Just go here to find out why becoming a member could significantly change your financial picture for the better.

Today’s Investment U Crib Sheet

There are two motives for selling 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. Over time, we’ve devised a system that ensures that… Your losses never get out of control and you capture profits while they’re still on the table.“Don’t lose money” sounds easy, but it’s a tricky business. A good money manager can’t just buy smart… he’s got to sell smart, as well. Most investors - even professionals - don’t have a clue when to get out of a trade.

The point is not to put yourself in a position for a catastrophic loss. You can generally avoid being down 50% or 90% with a simple 25% trailing stop strategy. It’s a mainstay of our investment philosophy. Here’s how it works… Whenever a stock pulls back 25% from its closing high, sell the stock at market. You can set a trailing stop closer than 25% to your entry point depending upon your personal risk profile.For investors looking to protect gains, you can raise your trailing stop as a stock price climbs. This way, if it does fall down, you don’t lose your hard-won gains.

Using trailing stops ensures you’ll never let a small loss become an unacceptable loss. It also keeps you from selling your stocks while they’re still in a major uptrend. And it works.

The important thing, of course, is to have a sell discipline and stick with it. Anyone can buy a stock. Knowing when to sell it is the true art of investing. To find out more about trailing stops, check out Investment U Issue #426, Trailing Stops Tested: Do Trailing Stops Really Work?