The Benefits of Trailing Stops - Not Rocket Science, Just Simple Arithmetic

China Finance Online Co. Limited, (JRJC) is a Nasdaq company that provides online financial services in the People's Republic of China. The stock has risen steadily over the last month from around $10 per share to almost $25 as last week started, a terrific gain by anyone's standard. As the graph illustrates, last week, the stock price exploded, hitting a daily high of $26 on Monday, more than $30 on Tuesday and, $35 on Wednesday. Thursday was the craziest day of all. The stock leapt out of the gate, zooming up more than $10 to an intraday high of almost $45. What followed the rest of that day through Friday was quick and merciless; a classic stock blow off, where a stock experiences a steep and rapid increase in price followed by a steep and rapid drop.

Let's assume you were smart or fortunate enough to be along for this wild ride, getting in on Monday at $25. With a 10% trailing stop, you would have ridden the stock all the way up to $45, your 10% trailing stop, as its name suggests, "trailing" you up all the way. At $45 per share, your 10% ExitPoint trailing stop translated to a sell order at $40.50. As the stock started its precipitous descent that day, you would have exited the position well before the closing bell when the stock had declined to around $35. Friday, the last day of JRJC's tumultuous week, the stock dropped again to close just above $32. Your trailing stop in place, you, of course, were happily sitting on the sidelines.

It is true that had you bought and held JRJC through last week, you would still have profited handsomely, at least on paper. A rise from around $25 to $32 in one week, a gain of 28%, is terrific by anyone's book. Of course, with the benefit of your simple 10% trailing stop, you would have netted an astounding 80% gain. Indeed, for stocks experiencing such a dramatic and rapid rise, it is often prudent to tighten your trailing stop. (You can, for example, use ExitPoint's "Target" Strategy Setting to set a second trailing stop strategy that kicks in after a certain percentage gain is achieved).

Of course, you might not have been as fortunate to enter the position before the dramatic rise. Suppose instead, after hearing all the hype about a company whose price was appreciating, seemingly unabated, $3, $4, $5 or more every day, you decided to hop on the bandwagon, entering your position at $45. It happens to all of us so if this reminds you of an investment experience of your own, you're in good company. But once again, the flip side of protecting your gains is limiting your losses. There, a trailing stop is equally effective at preserving your capital. Had you used a 10% trailing stop, even entering into the position at $45, your loss would have been palatable. On the other hand, had you bought and held, you would have been looking at a loss in the order of 30%. (By the way, if you look on the "Practical Obstacles" section of the ExitPoint® Solution by clicking here, you'll notice that to just to get back to break even after incurring a 30% loss, you must earn a return of approximately 50%.) As I've said before, there's a reason why they say it's a whole lot easier to slide down a hill than it is to climb back up.

Before leaving the JRJC example, there's also another opportunity in a classic stock blow off that is worthy of discussion. Although not for the faint at heart, the stock presented a great shorting opportunity, as profit taking by sellers caused supply to suddenly outstrip demand. That being said, to short the stock without an exit strategy would have been foolhardy, particularly because unlike the case with long positions, losses on short sales are theoretically unlimited. Thankfully, trailing stops for shorts work just as well as they do for longs. Had you sold the stock short at $45, a 10% trailing stop would have caused you to exit your position if the stock rose to around $49.50, a loss to be sure, but hardly calamitous.

A few points to summarize or discussion:

1. The roller coaster ride of JRJC certainly is atypical, at least in such a compressed timeframe, but the lessons it teaches about the benefits of using trailing stops for long or short positions, have broad application.
2. There's nothing wrong with a buy and hold strategy per se if it suits your investment style and temperament. But this shouldn't be confused with a buy and hold forever strategy. Good stocks fall for many reasons, sometimes having nothing to do with the company itself, such as the overall condition of the market. Bad stocks don't usually require external reasons but can fall even faster in a troubled market. Trailing stops protect your gains and limit your losses. If you take away nothing else from this commentary, ingrain that mantra in your investment brain.
3. Don't expect to get in at the bottom or get out at the top. (If you can already do that, you don't need this or any other investment assistance.) Do expect, however, to avoid getting in at the top and getting out at the bottom. Using ExitPoint® to calculate your trailing stops will certainly protect you there.
4. Lastly, don't beat yourself up if you exit a position on a slight pullback only to see it head North again after you've sold. First, if a stock remains fundamentally sound, you can always reenter the position. Second, to borrow an old but timeless phrase that is always apropos to investing, bulls make money and bears make money, but pigs get slaughtered.

© 2007 ExitPoint LLC. All rights reserved.

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The author is the founder of ExitPoint.com, a a unique and innovative portfolio management website application that allows investors to easily track their stock, option and mutual fund investments and set trailing stop and fixed stop exit strategies for each security in their portfolios customized to their own tolerance for risk.