“Here’s what I don’t like about trailing stops,” an attendee told me at an investment conference last year.
“You get knocked out of a stock and a week later it’s higher than where you sold it.”
That’s a common refrain during bull markets.
And virtually never heard during a serious correction – or in a savage bear market like the one we’ve had this year.
There are plenty of knowledgeable, uber-confident talking heads on cable TV telling viewers how long bull markets will continue or when bear markets will end.
But here’s a not-very-well-kept secret… They have no idea.
Neither does Warren Buffett, Cathie Wood or Jerome Powell. No one knows.
Future stock market moves will depend on future news.
Not the highly probable developments that everyone expects. (Like another interest rate hike.) But news that seems unlikely or unimaginable.
Think 9/11, the housing bubble and collapse, the sudden fall of Bear Stearns and Lehman Brothers, the rise of the COVID-19 pandemic, or Russia’s invasion of Ukraine.
Those are only examples of terrible news, of course.
What gets shorter shrift is the good news: declining poverty, rising living standards, improving technologies, new lifesaving drugs and medical devices, and record incomes and household net worth.
The continual tension between good news and bad is why experienced traders often use trailing stops.
Anyone can plunk for a few shares of stock. But the art of short-term trading is knowing when to get the heck out.
Of course, you’ll never know the ideal time to get out of a position until you’re looking in the rearview mirror.
Then it’s blindingly obvious when you should have gotten in – and when you should have gotten out.
But when you look forward, you’re literally blind. All you see is a blank slate.
Trailing stops allow you to deal with this uncertainty.
They protect your profits in the good times… and your principal during the bad.
Let’s start with an example…
If you buy shares of XYZ at $20 and intend to use a 25% trailing stop, you enter a sell stop with your broker at $15, immediately after your buy order is filled.
At this point you have 25% downside risk – and unlimited upside potential. (Since there is no limit how high a stock can go.)
You never lower a sell stop. That would mean abandoning your sell discipline.
However, you raise your stop as a stock goes up.
If your stock rises to $30, your 25% sell stop would be at $22.50, guaranteeing you a 12.5% profit.
If the stock rises to $40, your 25% sell stop would be at $30, guaranteeing you a 50% profit.
While every stock has good days and bad days, the goal is to never sell a stock that is moving higher.
Instead, you wait for the stock to break its confirmed uptrend before selling.
That’s in a bull market. Or with a rising sector – or company – in a bear market.
While it’s true that you can stop out of a stock only to see it go higher afterward, trees don’t grow to the sky.
Every bull market eventually ends, as even investment newbies have learned this year.
Early in a bear market, trailing stops protect your profits. Later in a bear market, they protect your principal.
Trailing stops prevent your profits from slipping through your fingers. They also prevent a small loss from becoming an unacceptable loss.
It never feels good to take a loss. But it’s inevitable that some trades won’t work out.
(Although there are still opportunities to capitalize on significant bounces along the way, like the one that began in mid-June and then faded in late July.)
Short-term traders who are unwilling to cut their losses can put themselves in a hole.
For example, if you take a 25% loss on one trade, you need to earn just 33% on the reinvested proceeds to be made whole again.
But if you let a loss grow to 50%, you need to earn 100% on the next trade to break even.
And if you let a loss reach 75%, you need a 300% return on the next trade.
History shows that 33% gains are not that hard to come by. Three-hundred percent gains take a lot more time and patience.
However, time and patience are the investor’s hallmark. Not the short-term trader’s.
That’s why I recommend other strategies for the long-term positions in your portfolio.
I’ll discuss those in my next column.
P.S. Have you seen my new “2022 Market Massacre” collaboration with Chief Income Strategist Marc Lichtenfeld?
It’s a brand-new development that could help you not just survive the bear market – but come out significantly ahead.