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Do Trailing Stops Really Work?

by Alexander Green, Chief Investment Strategist Monday, June 14, 2010: Issue #1280

source: Do Trailing Stops Really Work?

While I was in Baltimore last week, one of our Oxford Club researchers, Matt Carr, told me over lunch that one of the most controversial aspects of our investment policy is trailing stops.

But they shouldn't be.

If you don't have a premeditated sell discipline - and the vast majority of investors don't - you're flying by the seat of your pants. And that rarely leads to superior investment performance.

But do trailing stops really work?

Survey Says: Use Trailing Stops

In a word: Yes. Trailing stops protect your profits and your trading capital. And there's much more than just anecdotal evidence.

In a study published in The Journal of Portfolio Management, Christophe Faugere, Hany A. Shawky and David M. Smith - finance professors at the State University of New York at Albany - researched the performance of money managers who oversee pension funds, endowments and high-net-worth accounts.

Because most institutions work under strict investment guidelines, these academics were able to analyze performance based on differing approaches to selling stocks.

The result? Institutional managers who fared best were those with restrictive rules that didn't allow much leeway for holding stocks for emotional reasons. Managers who relied on "flexible" sell strategies did far worse.

Count me as unsurprised. Institutional money managers are just as prone to rationalizing as individual investors when they make a mistake. (Hence the old Wall Street chestnut, "What does a broker call a trade gone wrong? A long-term investment.")

Trailing Stops: Providing Protection... Securing Profits

The culprit is almost always pride, ego, or emotion. Without any kind of sell strategy, emotions come into play. And emotions are almost always wrong.

But by adhering to a disciplined trailing stop strategy, our Oxford Club investment system mows down emotion-driven trading errors like a field full of dandelions.

It cures greed. Eliminates fear. And does away with wishful thinking - as in, "I hope this stock turns around and starts going the right way."

Of course, trailing stops aren't the only sell discipline out there. But they're one of the easiest to implement. They serve two purposes...
  • They make sure we never let a small loss become an unacceptable loss.
  • They keep us from selling stocks while they're still trending up.
According to the independent Hulbert Financial Digest, over the past 10 years our Oxford Club portfolios have beaten the S&P 500 by a wide margin. Part of our success has come from diligent research and careful stock selection. But part has also come from cutting our losses and letting our profits run.

Maneuver Past the Market Makers With TradeStops.com

The one knock against using trailing stops is that unscrupulous market makers will sometimes take out your stop order right before a stock takes off.

But Richard Smith, President and Founder of TradeStops.com - and a PhD in mathematics - has a service that provides an ingenious solution.

If you visit www.tradestops.com, you can enter the stocks you own, the price you paid and the percentage trailing stop you want to use. There are several valuable benefits...
  • If any of your stocks close beneath your selected stop, TradeStops sends a message - to your cell phone, e-mail, or account page - alerting you.
  • Some brokerage firms, like Fidelity, offer trailing stop alerts with their accounts. But they generally expire after 30 or 60 days. TradeStops information never expires and even offers a 30-day risk-free trial.
  • You can track up to 50 stocks at a time. (And whenever you stop out of one, you can replace it with another.)
  • TradeStops is easy to use. It's specifically designed for technophobes.
  • It's reasonably priced. Ordinarily, the cost is $7.95 a month or $79.50 a year. (If you're an Oxford Club member, you get a special rate of $39.95 a year.) There are additional services available for dedicated short-term traders who want even more.
  • It's important to note that TradeStops notifies you of stops, not your broker. And it doesn't enter sell orders. But the key is to make sure you have an acknowledged point where you'd be willing to sell any individual stock.
Trailing stops don't just offer to cut your losses and protect your profits. They guarantee it.

Good investing,

Alexander Green

Disclosure: No position