Sell Stops Revisited

As we are entering a new domestic buy cycle (hopefully one with duration), the question of the proper use of trailing sell stops has come up again.

Here’s what reader Al had to say:

Please explain how to execute a stop loss order on the end of day closing price as you stated in your last blog. I always use the 7% rule, but sometimes my equity will drop below the 7% intraday and trigger the stop loss order, then shed losses to close at a gain.

This is an important topic and, even though has been discussed many times in the past, it’s worth repeating. Here’s the process I use.

Upon investing in my new positions, I set up my spreadsheet to track all trailing sell stop points on the basis of day-end closing prices only in the case of ETFs. In other words, I treat my ETF holdings no different than my mutual fund ones in the sense that I want to see the 7% sell stop limit violated by the closing price of the day before taking any action.

Only after that has occurred, will I enter my order to sell the next trading day. In the case of ETFs, I never enter a stop loss order ahead of time since it has shown that intra-day moves can stop you out with the trend subsequently resuming.

Executing stops are not a clear cut black and white type scenario. Let’s say, at sometime in the future, based on the closing price, one of my holdings is down from its high -7.10%, which would indicate a sell the next day.

Since the 7% level has barely been broken, I may watch market activity for another day or so to see if there is a rebound. If there is, I will hold on to this position; if there is not, I will pull the trigger.

You need to look at the sell stop points not just as a hard number but a guide for you to determine whether action is warranted. That’s why the final price maybe slightly better or worse than the 7% loss objective due to market conditions.

Remember, depending on when your sell stop gets triggered, the goal is to limit your losses and avoid going down with a possible trend reversal. On the other hand, if the trend continues upwards for a few months before reversing, this little technique will tell you when it’s time to get out and cash in your profits.

To sum it up, using trailing sell stop points will do two things for you:

1. They will limit your losses in case the trade goes against you, and

2. They will lock in your profits if prices continue to rise until the trend ends.