Most
investors and traders spend far too much time
focusing on how to enter a stock and far too little
time focusing on how to best exit a profitable
position. What is particularly interesting regarding
this neglect is that most traders make the vast
majority of their profits in a year from just one to
five trades that move substantially in their favor.
Thus most traders would actually do better to focus
in on how to better exit heavily profitable trades
than they would to further refine their entry
techniques. I would like to briefly go over some of
our best "trailing stop" techniques to help
traders learn how to exit profitable trades much more
profitably. We use a number of trailing stop
techniques, but the simple rules of thumb we present
here should greatly enhance the trading of most
investors.
PATIENT INITIALLY, CAUTIOUS WHEN PRICEY
The
method we're going to briefly cover is used before a
stock becomes overvalued:
-- waiting for the breakout of a three- to four-week or longer
consolidation
-- putting stops below the low of that consolidation after
you've just entered a stock (as long as it is not
becoming overpriced on a price/earnings basis)
This requires patience for the first quarter of a move
after you've entered a stock (first 50 or so bars
after a trade on any timeframe). However,
when a stock starts to get a PE ratio that is both
higher than its historical high PE and above its
forward one-to-three year growth rate projected by
Wall Street analysts, then it is potentially becoming
overvalued, and investors should tighten up trailing
stops much more aggressively.
Once
a stock becomes overvalued, it is generally in a
blow-off. A blow-off can last from weeks to months,
and occasionally years - so the trick is to stick
with a stock for as long as it is likely to continue
running up, no matter how high the price and PE. This
is the essence of attempting to let profits run.
Thus,when a stock rises to a PE ratio that is both higher
than its historical high PE and above its projected
(by consensus analysts) growth rate for the next one
to three years, we use a different technique than the
one we used before the stock becomes overvalued. When
a stock becomes overvalued, we watch for any decline
in the close for two days in a row. Once we have a
two-day in a row decline in the close, we consider
that stock to be in a "reaction". Once a
stock is in a reaction, we wait for it to recover to
new highs. On any new high following a reaction, we
will then move our trailing stop to the low of that
reaction -- and we'll keep moving it up in this
manner on every reaction and subsequent new high. In
this way we are still waiting for a fairly
significant support point to be broken on the
downside before exiting a stock, but we are moving
our stops up much more aggressively than is the case
prior to the stock becoming overvalued.
Real
World Examples
Let's
take a brief look at how this works in the real world
using actual trades we made from 1999. These stocks
also appeared on Mark Boucher's Web page in
TradeHard.com.
Adobe
(ADBE) broke out to new 52-week highs in March, 1999,
and then developed a nice, tight trading range from
late-March to mid-April, creating just the type of
flag pattern we like to watch for an entry signal. It
was exhibiting strong relative strength, strong EPS
rank, strong quarterly earnings growth, had very
strong earnings growth estimates for the next year,
was the leader in its field, and was being
re-accumulated by funds--meaning that it met most of
our criteria for a runaway stock with fuel to go much
higher.
When
the four-week consolidation was broken to the upside
in April (near the 30 level) we started buying ADBE
for clients, it started appearing on our
Tradehard.com list of new highs, and it appeared in
our Portfolio Strategy Letter (PSL) model portfolio
in the April edition. The first trading range of three-four weeks following our
entry occurred in May, when ADBE declined from 40.53
to 33 1/2, a fairly large dip. In June, ADBE broke
out of this consolidation to new highs, and we
instigated our first trailing stop rule, using
trailing stop at 33, and we were finally able to
"lock in" a profit by having our stop above
our entry price. Other three-to-four-week-plus
consolidations developed in July-August and in
August-September, allowing us to again raise our
stops via the three-to-four-week-plus consolidation
and new high rule.
Then
in October ADBE took off and began to trade above a
P/E of 40. Forty had been a high P/E for the last
three years and was above earnings growth estimates
for the next two years after the one-year spike in
earnings expected in 1999. This meant ADBE was
potentially becoming overvalued, and was potentially
undergoing a blow-off in price. Thus
in October we began to use our tighter trailing stop
method on ADBE. Every time ADBE made a
two-day-in-a-row decline and then later broke to new
highs, we would move our stop below the low of that
reaction.
On
Nov. 1 and 2 ADBE made a two-day in a row decline. On
Nov. 4 ADBE bottomed at 67 1/8 and then made a new
high on 11/8. This was nothing close to a
three-week-plus consolidation, but since we were in
potentially overvalued territory, we used an open
protective stop (OPS) at 66 3/4 (just below 67 1/8).
The stock continued to explode to 79 before
collapsing, and we were stopped out via our 66 3/4
OPS in early-December as ADBE began a decline to the
50's.While
we didn't catch the top perfectly, we caught the
lion's share of this nice move, and we caught more of
the move by using a trailing stop than we would have
had we just began selling the position in October,
when it first began to look overvalued.
Our final example is a foreign stock traded on the
NASDAQ, Business Objects (BOBJ). In
mid-June, BOBJ broke out of a two-month consolidation
on the upside on a high-volume thrust and lap. It
showed strong RS, exploding earnings growth,
increasing-but-low ownership by funds, and other
elements of our runaway criteria. We began buying
BOBJ near the 30 level, and put it into our PSL model
portfolio in June. BOBJ
made a new high in July, corrected to the 37 level,
and then consolidated for two months before making a
new 52-week high again - which allowed us to move our
trailing stops to just below 37 where we locked in a
profit via our trailing stops.
BOBJ
took off on a runaway up-move, and in November it
moved above a P/E of 90 (its projected earnings
growth for the next year and a historic PE high).
Thus in November we switched to our tighter trailing
stop technique. On 1/6/00 BOBJ hit our stop at 115,
below the Dec. 14, 1999 lows, and we took some very
healthy profits.
In Conclusion
Remember
no trailing stop technique is perfect. Trailing stops
will often take you out of a stock that ends up
moving further in the desired direction. But even
more often, the trailing stop will prevent you from
letting your open profits erode substantially in a
stock that has peaked for a considerable period of
time. You can always re-enter a stock if it meets
your criteria on a new breakout. Trailing stops
therefore not only help you to let your profits run
and prevent you from giving back huge portions of
open profit, but they also help you to focus your
trading capital on vehicles that are moving up
strongly, right now, and exit those that are in
prolonged corrections.
