On Sell Stops and Whip-Saws

While I have discussed the use of sell stops and occasional whip-saws on several occasions, reader William had this to say:

I am following your guidelines and have started to cautiously invest a small portion of some of my IRA in some ETFs. I am putting a 7% trailing loss on them.

Let’s assume that my fund loses 7% of its value from its high, and we are still over the trend line and the market then starts going up again. I have sold the fund, what do I do with the money? Buy a different fund, reinvest it in the fund (at what point)?

Or is this a scenario that won’t happen realistically?

Also, another scenario is that we are under the trend line when my 7% trailing sell stop hits. I then reinvest when it goes back over the trend line, right. This could happen multiple times so I could loose up to 7% of 1/3 of my portfolio, then up to 7% of 1/3 of what is left of that etc. That starts adding up to real money real fast. I guess that we hope that out fund goes up at least 7% after we buy it so we at least sell at a neutral.

I hope this market finds real direction!

While all these things you describe can happen, they usually don’t. There are some precautions I take to minimize the possibility of a whip-saw signal. For one, I don’t jump in the market the moment one of the Trend Tracking Indexes (TTIs) crosses its long term trend line.

I want to make sure that the trend line is clearly penetrated by +1% as well as by waiting a few days to make sure the TTI remains above it.

For example, when the international TTI generated a Buy on 5/11/09, it had fulfilled those requirements before I actually pulled the trigger. We allocated 1/3 of portfolio value, and our positions subsequently gained over 8% before coming off their highs by -4.16%. This means if I implement the sell stop after a drop from the high of 7%, I will come out ahead by +1% or thereabouts.

The domestic TTI generated a new Buy signal on 6/3/09. If you missed that exact entry point, it’s no big deal yet since the market has not moved much, and you can enter at a later time.

As I’ve said repeatedly, missing a buy signal is not as crucial as neglecting a sell signal. The former will only cost you potential profits, while the latter can have a serious impact on your portfolio.

If you get stopped out at the worst point with a 7% loss that means, if you had only 1/3 of your portfolio invested, the impact on the total would be -2.33%, which is reasonable. Even if that happened 3 times in a row (unlikely, but possible), you will have lost 7% of your total portfolio. While you may not like it, it sure beats the alternative, which many investors experienced in 2008.

Once you’re back on the sidelines, the proceeds should be in money market. If the market stages a recovery, and the trend line is crossed again to the upside, repeat the process.

If you been stopped out prior, and the market turns on you and resumes the up trend, you have a decision to make in respect to re-entry. If I liked the fund/ETF I had chosen, I re-establish my position after the old high has been taken out. Remember, the idea of following trends is to be onboard when the trend is intact and not try to bottom fish when things head south.

Above all, you need to keep in mind that this is not an exact science or an engineering problem to which there is only one correct solution.

At major inflection points, when trends change, the danger exists that whip-saws will become part of the equation. Investing always involves an element of risk no matter what you do, but I have found that these ideas are suitable for most investors, because they contain a blue print to follow, although it may be far from being perfect.