Reader Vik has this viewpoint regarding the use of sell stops:

Thanks for all your work. I have expressed my views earlier but I will just repeat them. Trend tracking is excellent method of investing particularly when investing is not your primary job function.

You have already said that your clients would not like their profits vanish if you went purely by trends instead of 7% dip rule. I think this is more of educating them by historical examples of which method ultimately works better.

Over the past 20 some years, there have been quite a number of market pullbacks that would have turned a major profit into a loss (a cardinal sin of investing), had it not been for the use of trailing sell stops. During the roaring 90s, there was no reason to use anything but the trend lines as exit points, as the bull market was in full swing.

As we entered the first bust in 2000, the name of the game seemed to have changed, which made the use of a sell stop discipline an absolute must. In 2008, you could have gotten away with only using the trend lines as an exit point, but that is with the benefit of hindsight.

It’s a matter of simple math. Trend lines, such as used with my TTIs (Trend Tracking Indexes), move slowly and therefore have a lagging effect, which can endanger your unrealized gains, especially after severe market activity.

To demonstrate the lag, take a look at 2008 again. After we sold out on 6/23/08, the market corrected so violently to the downside that even after the low was reached on 3/9/09, we did not get a buy signal until 6/3/09.

Now let’s look at the current status of the domestic TTI. It is positioned +4.87% above its long term trend line. If the market heads down from here, your 7% sell stop will bail you out way before the TTI crosses its trend line to the downside, therefore locking in a higher profit.

Of course, if this were to turn into a whip-saw, we’d be looking for a new entry points as discussed in previous posts.

Regarding the above three issue you have with trend tracking:

1. Given how much time most people waste on useless endeavors, like watching TV, spending 5 minutes a day updating stop loss points seems hardly a task at all. I have found that most investors have way too many holdings, which makes updating sell stops more of a chore. For a million dollar portfolio, you should be in no more than 10-12 funds/ETFs.

2. Sometimes you do, but more often than not, you end up being stopped out at a profit as I posted in “Buy-In Vulnerability.”

3. Sure, trading restrictions are an issue we all have to deal with most of the time. Fortunately, ETFs have become the main player, which has solved this problem for many. I have some clients with Fidelity 401k funds, which we purchased at the last buy signal on 6/3/2009, and we have not been stopped out yet despite several pullbacks. I attribute this to a more conservative selection process, which you should use when dealing within a restricted playing field.

What it comes down to is for you to use the approach that you are most comfortable with, and that matches your day-to-day schedule best. I for one prefer the use of trailing sell stops as my exit points, but that does not mean you have to as well.

One of the more frequently asked questions is whether it’s too late to enter the market now if you have new money to deploy. Reader Tiff is facing that decision and had this to say:

I am in cash position at the moment with about 200k available to invest. Should I jump into the market now or should I wait for a correction? Bulls and bears are both appearing in the news a lot.

You always say in the newsletter that we should just follow the trend and let the market tell us when to exit. But in my case, am I too late to the game? Is now a good time to get in? Or is it always a good time to get in and then follow your trend line to get out?

While I have discussed that topic before, it’s an important one and bears repeating. The issue is obvious in that you risk buying on top of the market, but since no one can give you an answer as to how long this bull will stay alive, or if we are even close to topping out, you need to approach it differently.

When new clients come aboard, I like to use my definition of risk tolerance to arrive at that answer. Assume that you invest your entire amount at this time and the market declines right away (worst case scenario), thereafter leaving you with an about 8% loss after your sell stops have been triggered.

How will that affect you? Obviously, you won’t like it. But can you live with the fact that this is part of investing and that at times you need to take a small loss in order to avoid a big one?

If this is not acceptable to you, start out by investing only 50% and then increase that once the trend continues to the upside. This will cut your risk in half and exposes your portfolio to only a 4% loss.

Still too much? Invest only 1/3, which will reduce your risk even further.

This way, you have a plan in place to evaluate if based on risk factors you are emotionally fit to invest at this particular time. It sure beats trying in vain to determine whether this bull has more legs or not.

If none of these 3 scenarios sit well with you, simply don’t expose yourself to any market volatility by staying in cash, money market accounts or CDs.

Reader Bob has been following the trend tracking principles for a number of years. Here’s what he had to say:

I have followed your Trend Tracking method for several years. It seems that trends are getting compacted into shorter time periods. Thus I end up with “Buy-In Vulnerability.”

This was primarily due to the funds not gaining enough to overcome the 7% Sell-Stop level, and my wanting to preserve what little profit I had made before the big downturn.

Yes, being on the back side of this current credit bust can affect the trends in that they appear to have shorter durations than ever before.

A buy signal followed by a sell within a short period of time will always cause a small loss or a break even at best. It appears from your email that successfully avoided the 2008 market drop, which puts you way ahead of most investors, including professionals.

The best time to establish a new position is at the moment the price and trend lines of the TTI cross, and we move into bullish territory. That happened on June 3, 2009 for the domestic arena. Let’s look at an example.

At that time, I purchased QQQQ for some clients, which proceeded to move higher based on the general trend of the market. Early in February 2010, we experienced a sharp pull back and got stopped out of that position. Take a look at the 1-year chart for QQQQ:




You could not have scripted a better scenario for following trends. The left arrow shows our approximate entry point, while the middle arrow shows the point when our stop loss got triggered and moved us to the sidelines.

Since this trend lasted almost 8 months, we gained over 17%. Our basis for that sell stop point (the high reached) was 46.59, which got taken out in early March 2010 (right arrow) and would have offered a new opportunity for re-entry at that time. Last Friday, QQQQ closed at 49.03, which represents a nice gain for the re-entry period.

Again, if you are late to the party by allocating while the uptrend is in full swing, you risk a potential whipsaw, and a smaller profit, which is simply part of trend tracking.

I am not sure when you entered the market and experienced the Buy-In Vulnerability you described, but it does happen. While fund selection is critical, a little luck from time to time does not hurt either.

It would be interesting to know when exactly you bought the funds you were stopped out of in February. As you can see from the above example, we need to be in the market at least 6 months to overcome the sell stop level and sell at a profit.

Again, keep in mind that this is not an exact science, but merely a method to keep your portfolio safe when the bear strikes. Despite its shortcomings, my preference is to be on the sidelines at the appropriate time in order not to watch my portfolio get clobbered at a 50% rate.

Disclosure: We currently have positions in QQQQ.

Hat tip goes to reader Delo for pointing to Forbes’ article “They’re Clipping Your Dividends.” Let’s look at some highlights:

If you are a prosperous saver, the federal tax rate on your dividends is about to triple. What are you going to do about it?

The second thing to do is to get back into these stocks after the selling wave is over, but do it using a derivative that allows you to duck the tax. That derivative is a single-stock future. You contract now to buy a share that will be delivered to you some months hence.

While I appreciate the 2 solutions to the problem, I can’t see a not very sophisticated retired person getting involved with single-stock futures.

The other area that was not discussed was the fact that many dividend investors are not earning enough to push them in a high tax bracket, so the actual effect might not be as bad.

Nevertheless, tax increases are on the horizon, and I suggest that, if you are concerned, you meet with a competent tax advisor to discuss your personal situation. Many details are still not known so you may want to tackle this task later on this year.

One of the most frequently asked questions about trend tracking has to do with the implementation of trailing sell stops. How and when to use them along with tracking caused many readers to write emails and comments, many of which I used as new blog posts.

While you can hunt and peck through the blog archives for specifics, I thought it would be easier to compile all sell stop topics into one e-book and make it available to anyone. Thanks to my assistant, Lovel Evans, for doing the grunt work, this project has been completed and encompasses some 70 pages.

You can now download for free “(Almost) Everything You wanted To Know About Sell Stops…But Where Afraid To Ask.”

Feel free to pass it on to anyone who may have a use for it. Keep in mind that there is some redundancy, but I felt that relevant reader comments should be part of it even though they may have been discussed already.

The format is in reverse chronological order just like the blog posts. As time goes on, I may add new posts on the topic provided they have not been covered. I hope this helps you with your investment decisions when it comes to the use of trailing sell stops.

My latest No Load Fund/ETF Tracker has been posted at:

http://www.successful-investment.com/newsletter-archive.php

The major indexes gained again on hopes of a continued recovery.

Our Trend Tracking Index (TTI) for domestic funds/ETFs has now crossed its trend line (red) to the upside by +4.67% keeping the current buy signal intact. The effective date was June 3, 2009.



The international index has now broken above its long-term trend line by +7.41%. A Buy signal was triggered effective May 11, 2009. We are holding our positions subject to a trailing stop loss.



[Click on charts to enlarge]

For more details, and the latest market commentary, as well as the updated No load Fund/ETF StatSheet, please see the above link.