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Thursday, December 15, 2005

Where to set Trailing Stops

...Question from member about placing trailing stops on stocks with a profit:

Thank you for your service, I have begun placing a great deal of faith in your analysis. You made the following statement, "It would be wise to start protecting profits in this stock". That has always been a difficult proposition for me. What is the best methodology for determining where to place this physical stop? I have been whipsawed before on stocks and then I have place much lower stops only to have the stock keep dropping. What is the best way to place a fairly reliable stop without being premature? Thank you for your help.
MSW Member

My Answer:
Placing a physical stop is subjective and can be considered an art form rather than science. There is not a specific answer to the question but I will let you know how I set a stop in different scenarios. I read a book by Martin Zweig many years ago and agreed with the way he set trailing stops versus what other traders were doing at the time. CANSLIM has a stop loss sell rule on the breakout but the 7%-10% doesn’t apply when I have a 30%+ profit in the stock. At times, I like to give my stock some breathing room to give a normal correction that may penetrate a tight 10% trailing stop. Stan Weinstein gives a decent description of trailing stops in his book but sometimes these stops will sell your position prematurely if you buy volatile issues (typically hi-tech stocks).

If a stock I own starts to rise by 25% or more, I will look to raise the mental trailing stop slightly below the most recent low or support area (an area I think will receive support). If you cannot locate a support area, using a moving average is the next best thing (set the stop slightly below this moving average only if it has given support in the recent past). If a moving average hasn’t provided recent support then it doesn’t make any sense to use this line as a stop reference. An important factor when setting a stop is looking at the overall “M” in CANSLIM. Investors can give more leeway if the major indices are moving higher and the trend is bullish. In poor markets or volatile sideways markets, it would be wise to set your trailing stop tighter to protect from any bad news that may hurt your profits.

If you cannot locate a support area (point and figure charts will help with this), draw a trend-line that connects several recent lows and think about placing a stop slightly lower than this line. If the trend-line is drawn at an angle greater than 60 degrees, ignore this method as a pullback is probable due to the nature of the sharp up-trend. Over the years, I prefer to use trend-lines that represent support and/or resistance in a horizontal nature. If you look at the MSW chart analysis (through our link – members only), you will see that I have drawn trend-lines for the major market indices (both horizontal and angled). If the NASDAQ was to break one or both of these trend-lines, I would start to become bearish and defensive with my portfolio and many if not all of my mental stops would be transferred into physical stops to protect profits or possible losses in new positions.

I often look at the history of the stock (2-years) to see how it has corrected in the past. Using SIE as an example, I have kept it on the MSW Index while it corrected below the 50-d moving average because it did so in the past and I felt confident that it would continue the trend above the 200-d moving average. My stop in this case was just below the 200-d moving average, a line it respected for years. Any sharp drop below this line would present immediate danger and I would want to be out of the position as soon as possible. This method proved to be correct as the stock eventually ran from the low $60’s into the low $80’s without violating the longer term moving average.

Determine what a reasonable reaction would be in the specific stock that you are trying to set a stop for. Look at the stocks you have placed stops for in the past and determine if they were volatile hi-tech companies or slowing moving larger cap stocks that are more predictable. For a quick example, I would give Whole Foods (WFMI) a much larger trailing stop than I would with OptionsXpress (OXPS) because of their different histories and sectors. Both stocks are on the MSW Index for the same reasons but I must treat them differently because they act differently.


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