Get Out of Your Own Way with This Simple Change

Feb 05, 2021

Last week, I told you about one of the easiest and most important ways you can protect your money this year. And I got a lot of great questions and feedback I’d like to address today.

Let me start with this — YOU are an emotional being.

It’s gotten you this far in life… and that’s probably a good thing. But it’s almost certainly costing you money.

You see, I believe most people buying and selling stocks are actually pretty great at picking stocks. But they are terrible investors.

Don’t feel bad. In the past, I definitely would’ve said that about myself, too. (And I had the terrible track record to prove it!)

Just think about this for a minute…

When you buy a great stock, how do you decide when you’ll sell it? If you’re like most folks, you probably don’t give it much thought. But that’s a mistake.

This isn’t the type of decision you want to leave up to your “gut.” Save that for dinner, movies, relationships, and so forth.

When it comes to investing, the difference between being able to pick a great stock and make a profit may literally be just one thing…

Having a clear “exit strategy” for every investment you own.

Here at TradeSmith, we love trailing stops.

You probably figured that out already.

As I mentioned last week, a trailing stop is simply a “stop” (or sell) price set at a specific percentage below the current price of an investment.

As the price of that investment rises, the stop price “trails” or follows it higher. But if the price falls, the stop price stays the same. It never moves lower.

If or when the price of that investment closes below the trailing stop price, you simply sell that investment and wait for signs of a new uptrend before getting back in.

This means trailing stops can not only protect you from big losses in your worst-performing investments, but they can also help you “lock in” gains and realize even bigger returns from your winners.

And best of all, they do so while taking all the emotion out of investing, so you can sleep well at night.

That should be your biggest goal!

In other words, trailing stops are about as close to the “perfect” exit strategy as you’re likely to find. And we personally use and recommend them for just about every public-market investment out there, including individual stocks, exchange-traded funds (ETFs), most stock and bond mutual funds, and even options.

(Unfortunately, trailing stops are difficult to use in privately traded or less “liquid” assets like real estate, individual bonds, collectibles, etc.)

However, following last week’s issue, I also heard from several readers who wanted to try trailing stops, but were still a little confused about how to actually put them to use in their own investing.

So, over the next couple of weeks, I’m going to show you how to get started with the three types of trailing stops we recommend most often.

These include fixed-percentage trailing stops — which anyone can use — as well as the more customized and powerful VQ-based trailing stops and Health Indicator trailing stops available to TradeSmith subscribers.

We’ll start with fixed-percentage trailing stops. As you can probably tell by the name, these are stops that are placed at a fixed percentage – like 15%, 20%, or 25% – below the purchase price of an investment.

For the following examples, we’ll use a 25% trailing stop, but the idea is the same regardless of the percentage used.

Suppose we believe shares of Company ABC are likely to rise, so we decide to make an investment at $10 per share. Because we’ve decided to use a 25% trailing stop, our initial stop price would be set 25% below our purchase price, or at $7.50.

At this point, one of two things could happen: The stock price could move up as we expected, or it could fall. So, let’s take a look at what would happen to our trailing stop under each of those scenarios.

If the stock immediately moved lower, our stop price would NOT move lower with it. (Remember, trailing stops can only move higher, not lower.) It would remain at $7.50. If the stock were to keep falling and close below $7.50, we would sell our position the next day.

Because we chose a 25% trailing stop, we can rest assured we won’t lose much more than 25% even under a worst-case scenario.

Now, let’s take a look at what could happen if we were right, and the stock moved higher right out of the gates.

If the stock moved 10% higher to $11.00, our trailing-stop price would move higher along with it, to $8.25. Notice this is not only 10% higher than it was before (just like the current stock price), but also still exactly 25% below the current stock price.

No matter how high the stock price rises, this will always be the case.

If the stock moved higher to $13.34, our trailing-stop price would move to $10, equal to our entry price. At this price, our trailing stop would allow us to exit around “breakeven,” even if the stock suddenly turned lower.

If the stock really took off and hit $20, our trailing stop price would move to $15. In this case, we would be all but guaranteed to lock in a great profit no matter what happened next.

So, what percentage trailing stop should you use with your stocks?

The ideal percentage depends on the specific volatility — what we call the Volatility Quotient or “VQ” — of each individual stock. So, without access to our TradeSmith tools, there’s no way I can give you an exact recommendation for every investment you might own. But I can give you some general guidance.

Our research suggests somewhere between 20% and 30% is a good range for most stocks. This range is “tight” enough to protect you from suffering a big loss if you’re wrong, but in most cases will also give your stocks enough “wiggle room” to ensure you aren’t stopped out of a big uptrend prematurely.

We generally recommend 25% to split the difference, but you might lean higher or lower in this range depending on your personal risk tolerance or your conviction level in a particular stock.

I can tell you, we’ve done hundreds of studies on different investor portfolios. We’ve looked at the portfolios of individual “mom and pop” investors… the most successful analysts in the newsletter world… even the “best of the best” billionaire investors like Warren Buffett and David Einhorn.

And in almost all scenarios, putting a simple 25% trailing stop in place allowed those portfolios to perform much better.

I would say that the only exception to this rule involves higher risk, more speculative stocks. These typically include companies with tiny market caps, low trading volumes, and those in highly cyclical and volatile businesses like resource mining, among others.

These kinds of riskier stocks aren’t necessarily right for everyone. But if you’re going to own them, our research shows using a wider trailing stop of 40% on these stocks can produce better overall returns. Just be sure to keep your position sizes much smaller in these stocks to account for the wider-than-usual trailing stop.

Tracking your fixed-percentage trailing stops isn’t difficult, either. While our TradeSmith software can do it for you automatically, you can easily track them yourself in a basic spreadsheet.

To calculate your trailing stops, you really only need two pieces of information for each stock:

  1. The stock’s highest CLOSING price since you bought it.
  2. The fixed-percentage trailing stop you’d like to use.

The math works like this:

Trailing Stop Price = Highest Close Price Since Purchase – (Highest Close Price Since Purchase x Trailing Stop Percentage)

In our last example of a stock trading at a new high of $20 with a 25% trailing stop, it would look like this:

Trailing Stop Price = $20 – ($20 x .25) = $15

Notice I emphasized “closing” prices. This is because even the least-risky stocks sometimes experience big intraday price swings that can trigger stop prices before reversing.

Using closing prices helps to eliminate this “noise” and ensure you aren’t kicked out of a position prematurely.

Unfortunately, trailing-stop orders at most brokerages are typically based on intraday, rather than closing, prices. This is one of the biggest reasons we recommend tracking your trailing stops yourself, rather than placing them with your broker.

(The other has to do with the risk of “stop hunting.” While it’s probably less likely with today’s digital trading platforms than it was in the past, there may still be a risk that market makers — the firms that match buy and sell orders — could see your stop and exploit it.)

Now, for those of you who are not TradeSmith subscribers, let me be clear…

It’s true that fixed-percentage stops aren’t as advanced as our customized TradeSmith stops. But that doesn’t mean they can’t make a huge difference in your investing. And I can tell you this from my own personal experience…

A few years ago, before I joined the TradeSmith family, I bought a company you might have heard of called Advanced Micro Devices (AMD).

I won’t bore you with all the details about why I bought AMD. All you really need to know is that I thought the market had mispriced the stock and I was convinced it would quickly head much higher.

Well, as you can probably guess, that was not what happened. It went up a little, then it went down a lot more. I immediately began to second-guess my decision. And when it finally bounced back to near my entry price, I gave up and sold my shares for a small 3.5% loss.

A small loss is certainly better than a big one. It could’ve been worse. But it turns out if I had done absolutely nothing different except use a 25% trailing stop on that stock, the outcome would’ve been much different.

Instead of selling for a 3.5% loss, I would’ve held on for a 48% gain less than one year later.

That’s a HUGE improvement. And even better, I could’ve avoided the emotional rollercoaster that had led me to sell those shares too soon in the first place.

I hope today’s explanation helped clear up some confusion about the “basics” of trailing stops. Next week, I’ll show you how our more advanced TradeSmith stops work and how you can use them to make even more money from your investments.

How much more? Remember that AMD investment I just told you about? Well, if I had used a TradeSmith VQ-based trailing stop instead of a 25% trailing stop, I’d still be holding shares today. And I’d be up more than 1,000% in about four years so far.

I’ll tell you all about it next week. In the meantime, if you do nothing else, please consider removing some of the emotion from your financial life by using a 25% trailing stop on all your investments today.