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Trailing Stop Losses – Protection Against Catastrophe

I want to talk about portfolio protection today.

music selection:  “Cinnamon Girl” — Neil Young

weigh-in:  213.0 +0.2

Traders that let their emotions rule end up selling winners early (lock in my gains!) and holding on to losers too long (I’ll wait for recovery!)  This results in a portfolio that is short on big winners and high in big losers.  Clearly, a portfolio composed of no big losers and several big winners will outperform the opposite.  I’m going to show you a simple rules based approach to ensuring you don’t fall into these traps: the trailing stop loss.

I currently have a 25% trailing stop loss on all positions.  I’ve previously violated my own rule and suffered severe consequences such as a greater than 90% loss on VNR (I would have locked in a small gain if I had stuck to my rule).  In light of the market being at a high CAPE, I’m recommitting to following my stops.

A trailing stop loss is a heuristic rule to sell when the stock price falls before a predetermined percentage below the high water mark.  This method keeps you from holding onto dogs that are on their way to zero in hopes of a recovery. Remember that the trend is your friend!  It also allows you to protect large gains from turning to dust.  I use a 25% trailing stop on my positions.  This is calculated by taking the highest closing price during your holding period and multiplying by [high water mark] * (1.00 – 0.25).  If the stock closes below that price, sell the next day!  You can get back in after a three month uptrend.

I like to adjust my trailing stops to reflect gains from dividends and options premiums.  That formula looks like this: [(high water mark) – (collections)] * (1.00 – 0.25).  It is entirely possible to end up with a stop loss figure that is below zero.  These stocks have moved into “never sell” territory.

I like to track mine in a spreadsheet, updating my high water marks after daily close.  If you want a lower effort approach, there is a for fee service called Trade Stops that will send notifications to you.  There are less user friendly but completely free cell phone apps that will do the same as well.

For my options positions, I use a “hard stop” rather than a trailing stop. This means I do not adjust the stop loss for gains (the high water mark) and just go with a straight 75% of the strike price.  Since my positions are roughly 6 to 8 weeks, there isn’t much time to collect large gains.  I make one exception which is for my UVXY puts.  These can move 100% up in a short period time and fall back just as quickly.  I could easily get shaken out of a winning trade that has a peculiar volatility profile so I just grit my teeth and hold.  That has always worked out so far.

One twist that many traders like is that when a stock is a large gainer, to start protecting gains by “tightening the stop”.  To do this, you change your multiply to a smaller percentage.  So you might move from a 25% trailing stop to a 20% trailing stop.  The new formula looks like: [high water mark] * (1.00 – 0.20).  This provides greater protection while still giving a winner room to run.

I’ve covered asset allocation and position sizing in the past.  You also need trailing stop losses to make a three legged stool.

Devour your prey raptors!

{ 2 comments… add one }
  • Chris B November 17, 2016, 6:38 pm

    I’ve always been intrigued by the rationale for heuristics like this. There seems to be contradictions. For example, if I logically should sell any stake that has declined in value by X%, why should anyone else buy it? Should I not take an initial stake in any investment that has already declined by X%, applying the rule in advance? Why should my point of view, either as a current owner or prospective owner, affect the future of a security? If markets are efficient, and the new, lower price of the investment represents the same ROI you originally thought you were buying, why sell a good ROI just because you paid too much for it in the past?

    I say this as another person who lost too much by being shy with the sell button. The momentum effect is real, but it’s also true that the only way to buy, or avoid selling, near a bottom is to know when to buy or hold through a dip.

    • The Lizard King November 17, 2016, 7:07 pm

      The rule doesn’t speak to the rationality of your counterparty. It just ensures you personally make a rational decision. It can steer you wrong (shake you out too early) but more often than not, I find it is best to follow your stops.

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