A Lesson in Trailing Stops Brought to You by the Letters A, B and C

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


From the Mailbag:

I follow Wealthy Retirement and The Oxford Club very closely. I invest in stocks in Marc’s Compound Income Portfolio within The Oxford Income Letter, but I do not reinvest the dividends. I am retired and depend on that income for living expenses. I realize I am to put a trailing stop on these stocks. My confusion comes when I try to figure out the trailing stop, due to the fact that I take the dividends. Would you please explain how I establish a trailing stop with these stocks?

When it comes to The Oxford Income Letter’s Compound Income Portfolio, one of my favorite Sesame Street songs comes to mind: “One of these things is not like the others…”

That’s because the Compound Income Portfolio is the only Oxford Income Letter portfolio that does not always abide by The Oxford Club’s trailing stop policy. It’s not like the others.

The portfolio is designed to take advantage of the power of compounding through dividend reinvestment plans (DRIPs). When DRIPs are used, trailing stops are ignored. When the stocks trade lower, investors are buying more shares, lowering their cost basis and bumping up their dividend yields. Investors are advised to sell only when Marc discovers a fundamental change in the company. When that’s the case, he’ll let subscribers know.

But if the dividends are not being reinvested, the trailing stop principle should still be applied. Just like in The Oxford Income Letter’s other two portfolios – the Instant Income Portfolio and the High Yield Portfolio.

The Oxford Club’s trailing stop guideline is pretty simple. If a stock falls a preset percentage (typically 25%) below the highest price reached since the position was entered or the price at which it was purchased – sell it. As the share price appreciates, the stop is moved up to protect profits.

If the position goes the wrong way, the trailing stop limits losses so investors can move on to the next opportunity.

In the spirit of Sesame Street, as well as for the sake of simplicity, let’s take a look at how Big Bird would apply a 25% trailing stop to his investment.

Big Bird buys stock ABC for $10. He sets his trailing stop at $7.50. That’s 25% below Big Bird’s purchase price ($2.50 = 25% of $10).

All goes well and the stock trades up to $15. The stock has hit a new high, so Big Bird raises his stop to $11.25 ($3.75 = 25% of $15). Big Bird just locked in a 12.5% gain.

Things continue to go Big Bird’s way and the stock trades even higher. Big Bird’s trailing stop follows.

When it reaches yet another high, this time at $20, Big Bird raises his stop to $15 ($5 = 25% of $20). Selling ABC at $15 would result in a gain of $5, or 50%, less fees. Not too shabby. Way to protect your profits, Big Bird. And build your nest egg!

When it comes to collecting cash dividends, nothing changes. Big Bird’s trailing stop is still the same: 25%. However, once the dividend is paid, the stock will adjust down and so will your stop. If the stock in the example above pays $1 in annual dividends, Big Bird’s trailing stop is now $14. Let’s say, a year later, ABC trades down to $4. Big Bird sells it, banking a $5 gain on the sale of the stock.

But wait… there’s more.

Don’t forget about that juicy dividend income Big Bird has been pocketing. Adding that into the share price appreciation, Big Bird bagged a 50% return on his seed money ($1 + $4 = $5, or 50% of $10). A 50% gain is nothing to squawk at.

As you can see, setting trailing stops on your own requires a little elementary school math. It’s not difficult… and it goes a long way toward protecting your profits.

Good investing,