Trailing Stops: A Simple Way to Prevent Catastrophic Loss in the Share Market

People don't have a plan to get out of an investment. So they risk being stuck in a position where a stock they own is down 50%... and they need it to rise by 100% just to get back to break even. Only the stock continues to fall...

They may even find themselves in a position where a stock has fallen by 90%. But by the time it's down 90%, it has to rise by 900% just to get back to break even. That's asking a lot.

What I mean when I say "don't lose money" is: "Don't put yourself in a position for a catastrophic loss." You can generally avoid being down 50%, or 90%, with a simple strategy.

The simple strategy, using trailing stops. As a very rough rule of thumb, I recommend a 25% trailing stop strategy. Here's how trailing stops works:

Let's say you buy a stock at $10, and it rises to $20. If it falls by 25% down to $15, you sell, no matter what. It is a way to know when to sell your stocks and let your winners ride. It is an excellent last-gasp "safety" to get you out of a loser that you don't recognise (or aren't yet willing to recognise) as a loser.

In the late 1980s, I read the book Market Wizards: Interviews With Top Traders by Jack Schwager. It changed the way I invest. These "top traders" all had made fortunes from the stock markets. And all but one of the traders in the book followed the rule: "Cut your losses and let your winners ride."

The rule of cutting your losses and letting your winners ride does some amazing things...

• You can be right less than 50% of the time and still make money. For example, let's say you buy three stocks. You lose 10% on two and cut your loss. You make 25% on the third, and you're still in the black!
• Second, chances are you'll never have a "catastrophic" loss again. If a stock falls by 20% (from $10 to $8), then it has to rise by 25% for you to break even. That's possible. But if a stock falls by 80% (from $10 to $2), then that stock has to rise by 400% for you to break even - a fairly tall order, especially for a "dud" stock. I don't want to be in that position.
• You put yourself in the position for 450%- type gains. Most investors I know sell as soon as they see a gain of 25% or 50%. You only get a handful of big winners in your investing lifetime. And they really make up the bulk of your lifetime investment returns. So whatever you do, don't cut 'em off at 25% profit!

It's simple math for me... I try to invest with a 3- to-1 reward to risk ratio. So if I think I can make 75% in a stock, then I'm willing to "risk" 25% on the downside, by using trailing stops.

I make a point to always set my exit points right when I decide to buy something. Now it's easy to tell you this. But it's another thing to try and track it...

Tracking your trailing stops can be a pain to follow. But I have two excellent recommendations for how you can keep track of them - TradeStops and XLQ.

Trade Stops was actually started by a True Wealth subscriber with a Ph.D. in maths, Richard Smith. It's a simple, web-based way to track your trailing stops. It sends you an e-mail when one of your stops is hit. Couldn't get much easier. You ought to give it a try.

XLQ is a full-blown Excel interface that automatically brings stock quotes and company data into an Excel spreadsheet for you. With XLQCompanion, you can easily track your stops. It is free to try for 45 days. Visit www.qmatix.com for details. Leo, the creator of QMatix, is great - very helpful. Both Richard and Leo do a great job.

So how do you make 450% on a stock? You find a small stock, with no analyst coverage, with fantastic assets at a very cheap price. Then - most importantly - you let your winner run.

Steve Sjuggerud
for The Daily Reckoning Australia

Editor's Note: Dr. Steve Sjuggerud writes True Wealth, a monthly investment advisory that boasts one of the largest followings in the world. He specializes in safe, unique investments that have been overlooked by Wall Street, including gold coins, Japanese real estate, timberland, and Icelandic bonds. Steve also produces Sjuggerud Confidential, an exclusive service focused on more speculative trades that often prove to be highly profitable.

Quoted by The Wall Street Journal, Barron’s, and The Washington Post, Steve is the co-author of Safe Strategies for Financial Freedom, a best-selling book on investment strategies. He is a former stockbroker and vice president of trading at a $50 million international hedge fund. He holds a doctorate in finance (his dissertation covered emerging-market currencies) and has spoken at dozens of investment conferences around the country.

Sign up for Dr. Sjuggerud's daily e-letter here.

P.S. to get The Daily Reckoning direct to your inbox sign up to our free e-mail newsletter or if you prefer to use RSS, subscribe to the Daily Reckoning RSS feed.

Related Articles:

• None Found