On Wednesday, high oil prices and the Fed’s release of the minutes from its April 30th meeting sent the markets tumbling. At first, it appeared that the major indexes were able to withstand the relentless upward trend in oil prices but, when the Fed decreased its GDP growth forecast and increased its 2008 inflation and unemployment rate outlook, the damage was done and the bears took over.

It would now seem unlikely that further interest rate cuts are under consideration, at least not in the near term, which does not bode well for equities.

This does not mean that the current domestic up trend is derailed, but it is interrupted. We’re still above the neutral zone and will hold our positions subject to our trailing sell stop points. Here’s where our Trend Tracking Indexes (TTIs) stand in relation to their long-term trend lines:

Domestic TTI: +1.89%
International TTI: -3.41%

After the recent upswing, some type of correction is certainly in order as long as it does not mark the end of the trend. The fact that we can never be sure whether there is continuation to the upside is one of the main reasons that we ease into a buy signal with only 1/3 of our assets. If the trend continues, we will increase exposure; if it turns out to be a false signal, our exit strategy will get us out before major damage occurs.

In the meantime, I have ventured into some other sector ETFs showing strong upward momentum, which should act as an equalizer should the domestic market head further south.

My recent posts on the use of sell stops have caused some readers to ask a variety of additional questions. One of them came from Peter, who commented as follows:

First I want to say that I enjoy your blog very much. Recent articles on sell stops have brought up a question that has crossed my mind numerous times. Having used and read about “sell stops,” I would be interested to knowhow you arrive at your limit percentages…..i.e.: (7 percent)?

I have read of investors using anything from 3 or 4 percent to as high as 25 or 30 percent.I have never used a fixed percentage….rather a percentage based on thevolatility (guess work). I would like to refine this approach.

Using sell stops is not an exact science and neither is determining the size of the sell stop. Much depends on the volatility of the investment. I don’t deal with stocks but I now that due to higher volatility compared many mutual funds and ETFs, many investors work with stops in the 10% to 20% range. The exact number for an individual depends on his or her risk tolerance.

For slower moving mutual funds and ETFs in the general domestic and broadly diversified international markets, I use 7%. For faster moving ETFs that are exposed to sectors and countries, I have used 10%.

I know of several independent investment firms that use a flat 8% no matter which type of ETF they invest in. There is no hard and fast rule, except one. You need to give the market some room to move so that you don’t get stopped out at the slightest hiccup. For example, I have had a reader tell me that he was so afraid of losing that he has used stop loss points in the 3% to 4% area.

The result was that they rarely participated in a trend and had deal with constant whip-saws. From experience, I have found that 7% is a good range. It allows some room for market movement and, at the same time, limits my losses to an acceptable number.

For example, if I allocate 8% of portfolio value to a mutual fund/ETF and, if the markets head straight down after my purchase, I will lose around 7% (give or take) of my investment. Since I had only committed 8% to begin with, this means that my total portfolio is only negatively affected by -0.56% or so.

That’s a reasonable risk (to me), however, keep in mind that you may very well have 2-3 losses in a row, which would add up to a higher number. If that type of risk is too much for you, you should not be investing in the financial markets in the first place.

Yesterday’s review of the use of sell stops prompted one reader to post the following question:

When selling an ETF, should any type of limit be placed on the sell order, or just sell at market price? Buy and sell orders are new to me and I’ve just been buying at market price. I have not executed a sell yet, so any advice or links to information that anyone can share would be appreciated.

While this reader seems to be new to investing, he nevertheless brings up a valid point: What type of order should you use when purchasing ETFs?

My view is that you should always use a limit order and never buy at market price if you have that choice (and don’t need to sell at all costs). Here’s how I approach it:

First, I make sure that the ETF under consideration has a large enough average daily volume to accommodate my size order, which maybe a couple of million dollars. I want to be able to buy or sell without too much slippage in price. Depending on your order size, this may or may not be a consideration for you.

In may case, out of some 600 ETFs that I track, I have identified about 80, which have a high enough volume to facilitate my order at anytime. If my previous day closing price has indicated a buy for the next day, based on the current trend and momentum, then I am ready to place my order.

However, I usually watch the market activity for a couple hours or so into the trading day before taking action. Once I am ready to pull the trigger, I check the current price and place a limit order for that price. Even though I want to get onboard, I will not place a market order as it exposes me to, let’s call it, the vagaries of the market place. I may get a partial fill and may have to enter a different limit price, if necessary, to complete my order.

Again, the idea is not engage in any kind of scalping to squeeze out a penny in form of a lower price, but to participate in the developing trend.

As soon as my order is filled, I set up my tracking spreadsheet along with my trailing sell stop points. I update these every day and know where I stand at all times in regards to any Profits/Losses and proximity to my exit points.

Being clear and disciplined about the process eliminates emotional and irrational decision making, which will make your investment life a lot easier than working by seat of your pants.

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.

Not too long ago, I reviewed Michael Covel’s book “The Complete Turtle Trader,” which detailed the teaching of a trend following strategy, or trend tracking as I like to call it, by Richard Dennis.

As you may recall, Richard, a wealthy Chicago trader, decided to teach randomly selected students the art of unemotional trend following and proving in the process that successful investment skills could be taught to anyone.

Prior to that review, I had read Michael Covel’s book “Trend Following,” which is a masterpiece on the subject and features many techniques which I have used myself over the past 20 some years. If you have come to the conclusion that trend following is the way to go with your investments, you owe it to yourself to read this 400-page mother of all investment books. Here’s what you can expect to find out:

For more than 30 years, one trading strategy has consistently delivered extraordinary profits in bull and bear markets alike: Trend Following. Just ask the billionaire traders who rely on it…traders like John W. Henry, whose trading profits bought the Boston Red Sox!

Michael Covel goes right to the source, presenting powerful insights straight from the world’s top trend followers, and debunking Wall Street myths and misinformation from well-known pros who ought to know better. You’ll learn how to manage risk, employ market discipline and, when the moment is right, swing for the home run.

Keep in mind that there are different ways to incorporate a trend following strategy. Many of the featured top pros are CTAs (Commodity Trading Advisors), who use leverage with their approach to obtain superior results. However, you can apply many of the methodologies in a more conservative manner, as I do, and use these same techniques with no load mutual funds and ETFs.

No matter which way you go, the key issues remain discipline and controlling market risk, which every successful trend follower will use with utter abandon. Despite me having used many of the approaches in my advisor practice for a long time, I found this book invaluable in clarifying my own thoughts and, at the same time, be a guide to further improving my system.

It’s pretty much a given that, every time our Trend Tracking Indexes (TTIs) have us out of the market and in money funds, somebody (a client or a reader) will ask if we can’t use the idle cash to buy some ultra-short bond funds to enhance returns.

There are reasons why I don’t get involved in those types of securities, some of which have been addressed in “Broken Bonds,” by MarketWatch:

When it comes to investing, there are times when boring is good, when the idea is to find a safe haven in a fund that does a simple job, easily and without flash, the kind of mutual funds you can hold without fear of what happens the next time you look at your statement.

Investors today clearly recognize the danger in subprime asset-backed securities, but before all of the trouble started, these securities were considered safe enough to fit into the investment profile of a risk-averse fund like an ultra-short. Money managers looking to squeeze some extra returns from the market went down the slippery slope towards subprime debt supported by the ratings agencies such as Standard & Poor’s and Moody’s Investors Service, which had test-driven the securities and given them appropriate ratings. Managers thought they were within their designated safety parameters.

So much for perceived safety! I have found over the past 25 years that when our Trend Tracking Indexes, especially the domestic one, are below their long-term trend lines, we are without fail living in times of great uncertainty.

The markets are in bear territory heading further south or aimlessly meandering and going nowhere. During that period, it’s important not to have any market risk with your idle cash. Yes, it’s tempting to try to spruce up the yield a little bit, but it simply is not worth the extra risk as many have found out over the past year.

After the bursting of the tech bubble in 2000, or now in the midst of the Subprime/credit/housing crisis, the theme remains the same: Safety of your portfolio comes first, and investments are made with clearly defined entry and exit points to control the risk.

If you want to be totally out of the market, safely on the sidelines and isolated from any risk, ultra-short bonds are not the tool to use; U.S. Treasury only funds are.