Here's How Our Trailing Stop Strategy Works

If you do hold onto a falling stock too long, loss will often be far more than just 25%. And all it takes is one big loss to set an investor back for years.

Let's say you start off with $10,000. A year later you've made 25% ($12,500). Same for next year ($15,625), and next ($19,530). But then after three years of 25% annual gains, fourth year, you take a loss of 50%. It puts you back below where you started, at $9,766.

Now, let's say you had a 25% trailing stop during year you lost 50%. You would have been stopped out at $14,648. Then during following three years (when you again profited by 25% each year), your holdings would be $28,600 at end of that entire seven-year stretch.

However, if you didn't have a 25% trailing stop in place, after same seven-year period, you would only have $19,073, still below where you were prior to 50% drop!

Over seven years of this example, you'd be up 186%. That's an average return of over 26% per year, much better than you'd think. But pick your own example, and do math. Look back at your own portfolio. You'll see that cutting your losses is key to both getting good overall returns and avoiding lost years.

Examples from Our Files

This is best illustrated by some specific examples–real recommendations made by The Oxford Club. And fortunately, tech run-up and subsequent meltdown provided substantial proof that limiting your downside gives you more capital to invest in your winners.

Let's begin with a look at Adobe, innovative software company on (then) booming Nasdaq that we enthusiastically recommended. It zoomed up, with no sizable price correction, for 10 straight months. The stock kept achieving new all-time highs. Along way we kept adjusting upward our 25% trailing stop. Given that we bought in at $31, we kept locking in higher and higher profits. When technology and communications sectors finally began to correct, Adobe corrected along with them. But thanks to our 25% trailing stop, worst-case result for Oxford Club members turned out to be a profit of over 81%.

Contrast this approach to "buy and hold" strategy. The Nasdaq high techs had an amazing run. But when they began to unravel, things got ugly in a hurry. Compare our profit of over 81% to devastation that occurred among other high-tech stocks during same 10-month span. Amazon was down 60%, Qualcomm down 63%, Intuit down 66%.

Several companies witnessed declines of as much as 90%, and "buy and hold" crowd held all way down. That's what can happen when you hold a stock investment with no exit strategy. That kind of loss is hard to recover from. Just look at chart above, and you'll get a good feel for kind of long-term damage just one bad stock can do to your portfolio. Hang on too long... and it could take years to recover your loss.

In reality, most investors who say they're buying and holding will in fact panic in a bear market, especially a long grinding one. We saw it graphically in 2000-2002–the last bear market. Don't let this happen to you: Use a smart exit strategy that lets you capture majority of any profits–even a doomed one.

The System Is Not Fool-Proof

As good as trailing stop concept is, it's not perfect. For one thing, in particularly volatile stocks, you can get stopped out at a price much worse than you had hoped for.

Take Microsoft as an example. As stories circulated that Justice Department was proposing a court-ordered divestiture of company, its shares experienced serious volatility. Before ruling stock was trading at $79. The next trading day, Monday, stock opened at $67. Even if you had a $75 trailing stop in place you would have had to sell at $67 because that was next available market price to execute trade. Once a stop price is triggered, it becomes a "market price" sale, that is a sale at whatever market will bear. Normally that won't be a big problem, but sometimes volatility can make your target price impossible to fill, as in Microsoft example.

Domestic U.S. stock markets do not accept trailing stop orders. And for thinly traded stocks, they don't even accept "hard" stops. Exchanges outside U.S. seldom accept any stop orders at all. (Trailing stops move constantly based on stock price. Normal "hard" stops are put on at a particular price and remain regardless of what stock does.)

Trailing stops are changed according to what stock does–the higher it climbs, higher trailing stop is moved.

If exchanges won't accept these orders, there are two alternatives. Both are mental stops, either put on by you or by your broker. Either one of you–or both–must be on top of situation–always.

Value Trading–When Trailing Stop Might Work Against You in Market

By its very nature, value trading can work against trailing stop. Value trading–the system of buying strong companies at or near historical lows–implies that you may temporarily follow a stock down past a trailing stop before it begins to rebound. With a trailing stop in place, you may never see rebound.

And this happened to us recently. We recommended Debt Strategies Fund as a good way to play beaten-down, high- yielding corporate bond sector. At time, it was priced around $7. But, more importantly, it was yielding over 16% annually, making it a perfect candidate for our Oxford Income Portfolio.

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