I’ve been making a lot of adjustments to stop losses lately in my Peak Income service as a way of locking in some of our hard-fought gains. Recently I took a moment to explain to subscribers how and why I use stop losses as a risk-management tool. Now I want to give you a glimpse of what I told them.
There are two elements of every trade – the buy and the sell – and being a successful investor over time means getting both of them right.
Most investors put substantially all of their time and energy into the buy decision, but that’s a mistake. If you’re reasonably patient, buying is the easy part.
I’m a value investor, so I buy a stock or fund when I consider its price undervalued relative to its intrinsic value, its own history, and its peers. I generally like for the stock price to have stabilized and, ideally, to have started a new uptrend.
But beyond that, the buy decision is simply an exercise in narrowing down the pool to the very best ideas and in sizing the positions accordingly.
Selling, on the other hand… that’s the hard part.
Do you sell a stock or fund just because it’s had a nice run and is no longer as cheap as it used to be? Do you sell at some predetermined date? Or do you stubbornly buy and hold forever?
This is where a stop loss becomes so ridiculously valuable. You’ve probably heard the expression “let your winners run.” Well, you should take that advice, because it’s the foundation of most successful momentum and trend-following strategies, such as those run by Dent Research’s own Rodney Johnson and Adam O’Dell. But it works for stodgy old value investors like myself, too.
There is simply no reason to ever sell a stock if it’s performing well. As Adam likes to quote the great Isaac Newton: an object in motion tends to stay in motion. Let your winners run. Chances are, they can end up going a lot higher than you ever imagined they would.
And this is where stop losses really add their value.
Let’s say that you own a stock that has become something of a bubble name (think Tesla Motors, Twitter, or any high-flying story stock of recent years). You know the stock is overpriced… yet it keeps rising every day in spite of it.
So, what do you do?
You place a stop loss order a few bucks below the current price and then raise the price on that stop loss order as the price moves higher.
If the shares are trading for $100, perhaps a stop loss at $90 makes sense… if the shares continue to push higher to $110, perhaps raising the stop to $99 is sensible. Or if you’re really concerned about the potential for a price reversal, you can tighten the stop to just a couple dollars below the current price.
As for setting the precise levels, I’m somewhat subjective here. I’ll generally look at stock charts and choose my stop based on recent price movements, reevaluating the stop as the price moves higher. But other investors use more mechanical rules, such as a trailing stop set at a certain percentage.
For example, you may instruct your broker to use a trailing stop of 20%, which would automatically sell the position if it fell 20% from the highest point it reached since you purchased it. There is no “right way,” per se, just the way that works best for you or your strategy.
I do have one ironclad recommendation, though. I suggest always using stop losses based on closing prices rather than on intraday prices. And if you want to know why, think back to August 24, 2015.
If you recall, that was the day that the market stopped functioning, and several ETFs opened down by 50% or more, even when the stocks in their underlying portfolios were only down 2%-3%. Most ETF prices recovered to their fair value within minutes, but imagine if you had happened to own one and had a stop loss order attached to it? You would likely have gotten sold out at the bottom and lost half your money.
So I repeat, use stop loss order based on closing prices. This massively reduces your risk of getting spanked in a flash crash.
Most brokers don’t have a closing-price order option, so you’ll need to keep track of it yourself or use a third-party service. One that I use myself and would enthusiastically recommend is TradeStops. I enter every trade I place in Dent Research’s Boom & Bust newsletter and Peak Income, as well as my personal trading, into TradeStops. And I get an email alert sent to me when one of my stocks closes below its stop price.
Whenever you see an alert from me telling you that one of our positions was stopped out, you can bet that I myself was alerted by TradeStops.
I also have one last piece of good news for you. TradeStops has a special offer for Dent Research readers, selling the service for 50% off its regular price. If you’re looking to implement stop losses into your trades, I encourage you to give it a look.
Editor, Peak Investor