Buckle Up, Buttercup: Trailing Stops Are Your Portfolio’s Safety Belt

Kristin Orman By Kristin Orman, Research Analyst, The Oxford Club

Mailbag

From the Mailbag:

The Oxford Club insists on using stop losses for all positions. Last week, several positions were closed by this strategy, but then bounced back in the following day or two. How do you reconcile the stops with panic-selling?

Most people know that the road to riches is not a smooth one. But the Dow’s 1,000-point drop last week demonstrated how rocky it really is.

Shortly after the open, dozens of The Oxford Club’s trailing stops were triggered. In the case of one of our portfolios, every single position was liquidated.

It was an unprecedented move.

And though they seem to happen more and more frequently, “flash crashes” aren’t a monthly or even yearly occurrence. Last week’s sickening drop was one of those situations. The flash crash of May 6, 2010, was another.

Not that long ago, specialists were in charge of ensuring that the stock market remained orderly. They created demand or supply as necessary to maintain orderly movement in stock prices.

Today, most of these specialists have been replaced by electronic trading. As a result, the market is witnessing more dramatic swings in prices than ever before.

We exited our positions and protected many of our gains. In a few instances, we took a small loss. Nearly all of those stocks recovered a few hours or days later, leading many of our Members to question The Oxford Club’s trailing stop strategy… especially in today’s flash-crash trading environment.

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You never know if the next market tumble will be a temporary blip or something bigger.

When I was in high school, my best friend’s brother was in a horrible car accident. He wasn’t wearing his seatbelt and was thrown from the car.

He was lucky.

He was told that if he had not been hurled from the vehicle, his body would have been crushed along with the car. More than likely, he would have died.

Thinking about it still gives me chills, but do you know what? I still put on my seatbelt every time I get into a car. That’s because I know that my odds of surviving a crash are significantly better wearing one than hoping I am thrown clear of the wreckage.

I view stop losses and flash crashes the same way. Sure, you might get lucky like my friend’s brother and walk away from a temporary market plunge with your portfolio intact. But if it’s the big one, you are going to lose everything.

Seatbelts save lives and limit injury. Trailing stops save wealth and limit losses. Using them is just good risk management.

In rare instances, seatbelts are the cause of injury in a car crash. Likewise, in a small minority of cases, trailing stops cause investment losses.

It’s frustrating for any investor to take a loss by sticking to their trailing stop strategy, particularly if they watch the stock trade back up shortly thereafter. However, it isn’t nearly as discouraging if they are able to view trailing stops in the right light.

Many investors believe they use trailing stops to protect their wealth. They are partially right. Trailing stops are a great way to protect profits.

But when it comes to losses, it’s better to think of them as insurance. You pay a premium, occasionally in the form of small losses during a flash crash, to ensure you don’t lose your entire savings.

Markets go up and markets go down. It’s called volatility.

Right now, the daily swings have gotten more extreme. Stick to your trailing stops no matter what. In the long run, you will be glad you did. If more investors had stuck with their trailing stops during the 2008 market free fall, their losses would not have been nearly as devastating.

I’ve said it before. It’s not a matter of if the next stock market crash will occur; it’s a matter of when. At the same time, investors cannot afford to not be in the market. Trailing stops offer investors the security they need to handle risk in the current trading environment.

Good investing,

Kristin