Trailing sells stops are an important part of trend tracking in order to protect capital by guarding against vicious long-term trend changes such as we’ve seen last year.
Common sense would dictate that any investment approach should incorporate some kind of an exit strategy but, unfortunately, most investors and advisors have not caught on to that simple bit of investment wisdom.
From time to time, readers email me with comments on the implementation of sell stops. Let’s take a look at what Paul had to say:
I’d appreciate (and perhaps other readers as well) your expanding on the use of stops. I currently put them in place on any position with an ETF or stock since I cannot watch the market. Have you done any testing (like with your hedging strategy) that indicates using end-of-day close and some type of exit the following day is better than keeping a stop order on the books?
The idea is to follow the signals as they occur. I treat ETFs the same way as I do mutual funds in that I base my sell decisions on day-ending closing prices only. Intraday volatility can otherwise stop you out prematurely. This is not an exact science, nor a matter of right or wrong, but simply one of preference.
When a closing price hovers around a sell stop point, I may give it another day to see if the trend moves back up or if it clearly pierces my intended stop point to the downside. In other words, I am introducing a little bit of subjectivity to avoid a possible whip-saw.
Another reader commented as follows:
I appreciate your thoughts on exit strategies. Being at work during market hours, I’ve often relied on sell stops, which I reset based on closing prices. Granted, they’ve sometimes thrown me out of positions at inopportune times, but they’ve also saved some profits and limited some losses.
If I switched to alerts and submitted market sell orders before the next opening bell, the opening volatility could hurt since I couldn’t be sure what price my shares would bring. It’s too bad that I can’t delay submitting morning trades until the market has opened and settled down.
Again, when a sell stop has clearly been triggered, the goal is to follow it and get out of the market. It does not matter whether there is opening price volatility or not; there is no need for you to attempt to do some scalping in order to save a few dollars.
Keep the big picture in mind, which is to follow long-term trends until they end. When markets reverse direction, you’ll never know ahead of time whether that reversal can turn into a disaster with lightening speed such as it did last year.
On the other hand, a whip-saw signal is always a possibility. However, I consider such an event as simply cheap insurance to guard against major portfolio destruction such as we’ve seen in 2008.
Comments 7
Ulli,
Thanks for responding to my question about sell stops. It did clarify some aspects of my confusion.
Ulli:
I think I understand you 7% Stop loss but in your Investment Policy Statement under the Profit Taking discussion your example confuses me-you show a $100,000 account going to $120,000, dropping back to $108,000 & then going back up to $130,000 or more but if you had applied the 7% loss stop @ $120,000 you would have been sold out @ $111,600.
Anon,
My point was to merely show that portfolios can fluctuate over time. The individual sell stop discipline has nothing to do with it.
I will rework that section to make it better understandable.
Thanks for pointing it out.
Ulli…
Hi Ulli,
Thanks again for you great posts. I know that using sell stops is advice often made about management of trend trading. I personally do not use them. Rather, my portfolio of 30 stocks in the Australian market (which gave a buy signal for me about a month ago, ie same time as your international signal)is wathched like a hawk. I use price and volume indicators, and now I can actually see where the market can come back to. Any violation – then sell the next rise in price. As well, a 7% stop below a resistance level might get whipsawed – I would prefer a 2-3 % stop loss below the last low if I was going to use them.
The most recent pullback from resistance in the Australian market was 6%
cheers
David
David,
Whatever works. It does not matter which exit strategy you use as long as you use one.
Ulli…
I recently watched a series of trading strategies which discussed exit plans. Out of 5 or 6 different stop strategies, the 20 day moving average provided the greatest returns and lowest drawdown. Just something else for traders to look at.
Hi Ulli,
Yes, the point is to not risk capital. For what it is worth, I have recently found that the Australian market is finding support at the 35 day moving average. One way to move into a market with tighter initial stops is to find the moving average in that market that has acted as support at previous lows, and then aim to get in to the market at that moving average. The S&P; 500 has been finding support at about the 20 day moving average (which makes it a strong trend!). Current close (06/05/09) is 3% above the 20 day moving average. If I was moving into S&P500; stocks I think I would wait for the next revisit of the 20 day average, and then make sure that closing prices behaved in a manner similar to recent visits.
The nice thing about this form of timing entries is that the portfolio can pretty quickly move into profit. Moving in when price is 6% above the 20 day moving average could lead to a a few days or weeks of negative portfolio balances.
Good trading to all.
David