Wednesday, September 12, 2007

Always Use Protection! Sell-Stops for Safe Investing

For most individuals, whether to sell a stock is the hardest decision in stock investing.

It sounds simple at first: Sell your losers and let your winners run. Sure, obviously. But how do you know which stocks are your future long-term winners and losers? More to the point, how do you tell the differenceright nowbetween a stock that is only on a short-term losing streak as opposed to one which is destined to be a long term loser?

Clearly, its easy to list your winners and losers as of right now. But thats not what this particular decision is about. This is about future eventsunknowable by definition. Even if your stock is falling in price, you dont want prematurely to decide that you made a mistake buying it or that its prospects have reversed from bright to dim. It may not be a loser at all. It just may have hit a bad patch. Your original positive outlook on the company and its stock may be correct, and the optimum decision may be to give the stock more time to reach its profitable destination. A stock in a short-term stall can become a long-term winner.

On the other hand, we all know Rule #1 of investing: Dont lose. So you cant wait forever to make your decision when a stocks price keeps falling.

Every Sensible Stock Investor wants to take a strategicnot whimsicalapproach to making sell decisions. You want to contain losses and sidestep risks.

The trailing sell-stop order is a very effective tool for sticking to a strategic approach. Lets make sure we understand what this order is. Then well talk about how to use them.

A trailing sell-stop orderwhich is a standard type of order with all brokerageshas these characteristics:

It is a sell order with a condition attached. You attach it. When the condition is satisfied, the order to sell is executedwhether you are at work, in the bathroom, on vacation, or wherever.

The condition is the ''stop'' price. That is the price you pre-select to trigger the sell order. If the stocks price falls to or through that point, the sell order is executed. You pre-select the trigger price when you are thinking objectively and strategically, not in the heat of a fast-moving stock price.

It is a trailing order. Over time, as the price of your stock moves up, you reset the trigger price a little highersay once per week. That way, the stop price trails along behind the stocks actual price, protecting you on the downside while not limiting your upside.

It is a standing order. That means it just sits there until (1) it is executed, (2) it expires, (3) you change it, or (4) you remove it.

Of course if the stocks price is going down, you leave the existing stop price alone. The whole idea is that it is there to protect you against losses. It does not take long to review and reset all the stop prices in a small portfoliomaybe a minute per stock online.

So trailing sell-stops are used to limit losses from your purchase price or to lock in the gains of your stocks as they advance. A trailing stop order gets you out if the stock suddenly starts to tumble. It works like a ratchet, letting your stock price move up but not down past the trigger price you have selected.

I follow one hard-and-fast rule: Sell a new purchase before losing 10 percent in it. So as soon as I purchase a stock, I enter a sell-stop order too, usually at 8 percent less than I paid for it.

After a stock gains 10 percent for you, your stop price will have reached what you paid for it, so you will never lose money on that stock. After that hurdle has been cleared, how do you set the stop price? The goal is to give the stock enough room for normal volatility, while at the same time being restrictive enough so as not to let profits escape if the stock starts to go backwards.

There are two main methods to set stop prices. First, you can set the stop price as a percentage below todays price (but never below what you paid once the stop price has reached your purchase price). I use the percentage approach most of the time. My default percentage is 15 percent, although I may change that (up or down) in certain situations.

I might use a looser stop (such as 20 or even 25 percent) for a blue chip company that I really expect to hold for a long time. This would typically be a company that has a fat dividend yield.

I usually use 10 percent if the stock is an ETF (exchange-traded fund). This is because funds are typically less volatile than company stocks, so they dont need as much wiggle room.

And I might use a stop as low as 2 percent or 3 percent for a stock that I have decided to sell. The tight stop price lets me squeeze out any unexpected upside that the stock may have left in it, but it still gets me out with negligible damage if the stock falls at all.

The second way to set the stop price is to examine the stocks chart for the past year or so. You may see that while overall the stock has been rising, some significant leaps and falls are part of its normal behavior. The dips may exceed any reasonable percentage sell-stop that you would normally set. But you dont want to sell the stock on such dips, because you can see that the overall trend has been upward, and you believe that it will be continue to be that way.

In that case, what I usually do is have the charting software (available on most financial websites) draw the stocks moving average line (MA). Try MAs between 50 and 200 days. What you might discover is that although the stock has its ups and downs, it essentially never falls below one of those moving average linesit always seems to bounce off the MA line and head back up. If thats the case, use that MA as the stop price.

This has worked perfectly for me with Chicago Mercantile Holdings (CME). Viewed through a wide-angle lens, the stock has done nothing but go up since it went public a few years ago. But viewed up close, it can be volatile. A couple of times I purchased it, only to have it trigger my stop order before too long. Then I made the observation that the stock never seemed to drop below its 200-day MA. So now I use that for my stop price. As the stock bounces around, the actual percentage of the stop price below the actual price varies. But I dont care. By using that approach, Ive held one block of shares without interruption since February 2006, and it is up 43 percentnearly 50 percent on an annual basis. CME is one of my all-time favorite stocks. The Merc has an exceptional business model, generates cash faster than McDonalds makes burgers, and has rewarded its shareholders handsomely. I am protected to the downside on a fairly volatile stock. Just as with percentage-based stops, I reset the stop price once a week. I just look up the current 200-day MA, and thats my stop price.

If you employ trailing sell-stop orders, you will find from time to time that you are stopped out of a stock that, as things turn out, you would have been better off just hanging on to. But thats OK. Cutting losses and preserving gains are so important to overall success that the risk of getting stopped out is preferable to the risk of taking a large loss. And, if a stop-out proves to be a mistake, you can reverse it. As the situation clarifies, nothing prevents you from repurchasing the stock.

Dave Van Knapp is the author of Sensible Stock Investing: How to Pick, Value, and Manage Stocks.

This guide for individual investors goes into more depth on trailing sell-stops, as well as other aspects of managing a stock portfolio. The book has a perfect 5-star reader rating on

Click here to learn more about the book and the Sensible Stock Investing methodology: