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Always Use Protection! Trailing Sell-Stops
for Safe Investing
by Dave Van Knapp, author of
SENSIBLE STOCK INVESTING:
How to Pick, Value, and Manage Stocks
and
THE TOP 40 DIVIDEND STOCKS FOR 2010:
How to Generate Wealth or Income from Dividend Stocks
May, 2007
The best players win the most with their good hands and lose the least with
their bad hands. —Poker maxim
For most individuals, whether to sell a stock is the hardest decision in stock
investing.
It sounds simple at first: “Sell your losers and let your winners run.” Sure,
obviously. But how do you know which stocks are your future long-term
winners and losers? More to the point, how do you tell the difference—right
now—between a stock that is only on a short-term losing streak as opposed to
one which is destined to be a long term loser?
Clearly, it’s easy to list your winners and losers as of right now. But that’s not
what this particular decision is about. This is about future events—unknowable
by definition. Even if your stock is falling in price, you don’t want prematurely
to decide that you made a mistake buying it or that its prospects have reversed
from bright to dim. It may not be a loser at all. It just may have hit a bad patch.
Your original positive outlook on the company and its stock may be correct, and
the optimum decision may be to give the stock more time to reach its profitable
destination. A stock in a short-term stall can become a long-term winner.
On the other hand, we all know Rule #1 of investing: Don’t lose. So you can’t
wait forever to make your decision when a stock’s price keeps falling.
Every Sensible Stock Investor wants to take a strategic approach to making sell
decisions. You want to contain losses and sidestep risks.
The trailing sell-stop order is a very effective tool for sticking to a strategic
approach. Let’s make sure we understand what this order is. Then we’ll talk
about how to use them.
A trailing sell-stop order—which is a standard type of order with all
brokerages—has these characteristics:
• It is a “sell” order with a condition attached. You attach it. When the
condition is satisfied, the order to sell is executed—whether you are at work, in
the bathroom, on vacation, or wherever.
• The condition is the “stop” price. That is the price you pre-select to
trigger the sell order. If the stock’s price falls to or through that point, the sell
order is executed. You pre-select the trigger price when you are thinking
objectively and strategically, not in the heat of a fast-moving stock price.
• It is a “trailing” order. Over time, as the price of your stock moves up,
you reset the trigger price a little higher—say once per week. That way, the stop
price trails along behind the stock’s actual price, protecting you on the downside
while not limiting your upside.
• It is a “standing” order. That means it just sits there until (1) it is
executed, (2) it expires, (3) you change it, or (4) you remove it.
So trailing sell-stops are used to limit losses from your purchase price or to lock
in the gains of your stocks as they advance. The trailing stops get you out if the
stock suddenly starts to tumble. They work like ratchets, letting your stock price
move up but not down past the trigger price you have selected.
I follow one hard-and-fast rule: Sell a new purchase before losing 10 percent in
it. So as soon as I purchase a stock, I enter a sell-stop order too, usually at 8
percent less than I paid for it.
After a stock gains 10 percent for you, your stop price will have reached what
you paid for it, so you will never lose money on that stock. After that hurdle has
been cleared, how do you set the stop price? The goal is to give the stock
enough room for normal volatility, while at the same time being restrictive
enough so as not to let profits escape if the stock starts to go backwards.
There are two main methods to set stop prices. First, you can set the stop price
as a percentage below today’s price (but never below what you paid after the
initial 10 percent hurdle has been cleared). I use the percentage approach most
of the time. My “default” percentage is 15 percent, although I may change that
(up or down) in certain situations. For example, I might use a stop as low as 2
percent for a stock that I have decided to sell. The tight stop lets me squeeze
out any unexpected upside that the stock may have left in it, but it still gets me
out with negligible damage if the stock falls at all.
The second way to set the stop price is to examine the stock’s chart for the past
year or so. You may see that while overall the stock has been rising, some
significant leaps and falls are part of its normal behavior. The dips may exceed
any reasonable percentage sell-stop that you would set. But you don’t want to
sell the stock on such dips, because can see that the overall trend has been
upward, and you believe that it will be continue to be that way.
In that case, what I usually do is use the stock’s moving average line (MA). Try
MA’s between 100 and 200 days. What you might discover is that although the
stock has its ups and downs, it essentially never falls below one of those moving
average lines—it always seems to “bounce” off the MA line and head back up.
If that’s the case, use that MA as the stop price.
This has worked perfectly for me with Chicago Mercantile Holdings (CME).
Viewed through a wide-angle lens, the stock has done nothing but go up since it
went public a few years ago. But viewed up close, it can be volatile. I made the
observation that the stock never seemed to drop below its 200-day MA. So I
use that for my stop price. As the stock bounces around, the actual percentage
of the stop price below the actual price varies. But I don’t care. By using the
200-day MA, I’ve held one block of shares without interruption since February
2006, and it is up 43 percent—nearly 50 percent on an annual basis. I reset the
stop price once a week to the current 200-day MA.
If you employ trailing sell-stop orders, you will find from time to time that you
are “stopped out” of a stock that, as things turn out, you would have been
better off just hanging on to. But that’s OK. Cutting losses and preserving gains
are so important to overall success that the risk of getting stopped out is
preferable to the risk of taking a large loss. And, if a stop-out proves to be a
mistake, you can reverse it. As the situation clarifies, nothing prevents you from
repurchasing the stock.
for Safe Investing
by Dave Van Knapp, author of
SENSIBLE STOCK INVESTING:
How to Pick, Value, and Manage Stocks
and
THE TOP 40 DIVIDEND STOCKS FOR 2010:
How to Generate Wealth or Income from Dividend Stocks
May, 2007
The best players win the most with their good hands and lose the least with
their bad hands. —Poker maxim
For most individuals, whether to sell a stock is the hardest decision in stock
investing.
It sounds simple at first: “Sell your losers and let your winners run.” Sure,
obviously. But how do you know which stocks are your future long-term
winners and losers? More to the point, how do you tell the difference—right
now—between a stock that is only on a short-term losing streak as opposed to
one which is destined to be a long term loser?
Clearly, it’s easy to list your winners and losers as of right now. But that’s not
what this particular decision is about. This is about future events—unknowable
by definition. Even if your stock is falling in price, you don’t want prematurely
to decide that you made a mistake buying it or that its prospects have reversed
from bright to dim. It may not be a loser at all. It just may have hit a bad patch.
Your original positive outlook on the company and its stock may be correct, and
the optimum decision may be to give the stock more time to reach its profitable
destination. A stock in a short-term stall can become a long-term winner.
On the other hand, we all know Rule #1 of investing: Don’t lose. So you can’t
wait forever to make your decision when a stock’s price keeps falling.
Every Sensible Stock Investor wants to take a strategic approach to making sell
decisions. You want to contain losses and sidestep risks.
The trailing sell-stop order is a very effective tool for sticking to a strategic
approach. Let’s make sure we understand what this order is. Then we’ll talk
about how to use them.
A trailing sell-stop order—which is a standard type of order with all
brokerages—has these characteristics:
• It is a “sell” order with a condition attached. You attach it. When the
condition is satisfied, the order to sell is executed—whether you are at work, in
the bathroom, on vacation, or wherever.
• The condition is the “stop” price. That is the price you pre-select to
trigger the sell order. If the stock’s price falls to or through that point, the sell
order is executed. You pre-select the trigger price when you are thinking
objectively and strategically, not in the heat of a fast-moving stock price.
• It is a “trailing” order. Over time, as the price of your stock moves up,
you reset the trigger price a little higher—say once per week. That way, the stop
price trails along behind the stock’s actual price, protecting you on the downside
while not limiting your upside.
• It is a “standing” order. That means it just sits there until (1) it is
executed, (2) it expires, (3) you change it, or (4) you remove it.
So trailing sell-stops are used to limit losses from your purchase price or to lock
in the gains of your stocks as they advance. The trailing stops get you out if the
stock suddenly starts to tumble. They work like ratchets, letting your stock price
move up but not down past the trigger price you have selected.
I follow one hard-and-fast rule: Sell a new purchase before losing 10 percent in
it. So as soon as I purchase a stock, I enter a sell-stop order too, usually at 8
percent less than I paid for it.
After a stock gains 10 percent for you, your stop price will have reached what
you paid for it, so you will never lose money on that stock. After that hurdle has
been cleared, how do you set the stop price? The goal is to give the stock
enough room for normal volatility, while at the same time being restrictive
enough so as not to let profits escape if the stock starts to go backwards.
There are two main methods to set stop prices. First, you can set the stop price
as a percentage below today’s price (but never below what you paid after the
initial 10 percent hurdle has been cleared). I use the percentage approach most
of the time. My “default” percentage is 15 percent, although I may change that
(up or down) in certain situations. For example, I might use a stop as low as 2
percent for a stock that I have decided to sell. The tight stop lets me squeeze
out any unexpected upside that the stock may have left in it, but it still gets me
out with negligible damage if the stock falls at all.
The second way to set the stop price is to examine the stock’s chart for the past
year or so. You may see that while overall the stock has been rising, some
significant leaps and falls are part of its normal behavior. The dips may exceed
any reasonable percentage sell-stop that you would set. But you don’t want to
sell the stock on such dips, because can see that the overall trend has been
upward, and you believe that it will be continue to be that way.
In that case, what I usually do is use the stock’s moving average line (MA). Try
MA’s between 100 and 200 days. What you might discover is that although the
stock has its ups and downs, it essentially never falls below one of those moving
average lines—it always seems to “bounce” off the MA line and head back up.
If that’s the case, use that MA as the stop price.
This has worked perfectly for me with Chicago Mercantile Holdings (CME).
Viewed through a wide-angle lens, the stock has done nothing but go up since it
went public a few years ago. But viewed up close, it can be volatile. I made the
observation that the stock never seemed to drop below its 200-day MA. So I
use that for my stop price. As the stock bounces around, the actual percentage
of the stop price below the actual price varies. But I don’t care. By using the
200-day MA, I’ve held one block of shares without interruption since February
2006, and it is up 43 percent—nearly 50 percent on an annual basis. I reset the
stop price once a week to the current 200-day MA.
If you employ trailing sell-stop orders, you will find from time to time that you
are “stopped out” of a stock that, as things turn out, you would have been
better off just hanging on to. But that’s OK. Cutting losses and preserving gains
are so important to overall success that the risk of getting stopped out is
preferable to the risk of taking a large loss. And, if a stop-out proves to be a
mistake, you can reverse it. As the situation clarifies, nothing prevents you from
repurchasing the stock.
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