Money

When to Use Trailing Stops

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State of the Market

In this week’s episode of his YouTube series State of the Market, Chief Income Strategist Marc Lichtenfeld takes the road less traveled…

Recently, Marc shared the story of the worst trade he ever made. But in this week’s video, he uncovers more about the strategy that could have spared him a $7,000 loss.

The secret? Set trailing stops on your trades.

A trailing stop, or a stop loss, is a predetermined price at which you’ll sell your position if it drops. Wealthy Retirement‘s publisher, The Oxford Club, recommends setting these at 25% of the stock’s current price.

Because The Oxford Club recommends position-sizing guidelines in which no position makes up more than 4% of your total portfolio, that means the most you can ever lose on a trade is 1% of your portfolio.

A stop is “trailing” when it rises along with the value of the stock.

For instance, if you buy a stock trading at $60 and set a 25% trailing stop, you’ve decided that should the stock drop to $45, you would cut your losses and sell.

If the stock soars to $72, that stop would rise to $54.

(Alternatively, you could tighten your stop to 15% and sell should the stock close below $61.20, ensuring that a win didn’t turn into a loss.)

No rationalizing, no emotional decision making… just a hard cutoff point at which risk tolerance triumphs over hopeful “what ifs.”

Note that stops can be set on either an intraday basis or a closing basis.

Marc recommends setting trailing stops on a closing basis to avoid getting shaken out of solid stocks by market noise during the trading day.

And in the same spirit, while trailing stops can save investors from catastrophe, Marc doesn’t recommend using them on all of your positions.

If you are a dividend reinvestor, sharp downturns like the one we witnessed last March could actually set you up for long-term profits.

Consider this…

If the stock you previously bought at $60 plummets to $45 in a prolonged market rout that isn’t specific to the business, and if the company’s fundamentals and dividend-paying abilities haven’t changed, you have a unique opportunity.

Your dividends will be able to buy more shares, which will generate more dividends, which will be able to buy more shares…

This process turbocharges the compounding machine – and in this case, selling when your stock hit $45 would interrupt your profits.

But in both cases – whether you kept your stop at $45 or you decided to hold that stock for the long haul and reinvest the dividends – there was a strategy at play.

You would have factored in your risk tolerance and long-term financial goals to decide on the exit strategy that worked for you, sparing yourself the agony of emotional decision making down the road.

Click here to see this week’s episode of State of the Market and learn more about when it pays to use trailing stops.

Good investing,

Mable

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