The Oxford Insight – August 12, 2008 (Broadcast #794)
In This Insight
** The Single Best Way to Safeguard Your Portfolio
By Alexander Green, Oxford Club Investment Director
Two weeks ago, I detailed the reasons why we recommend running a trailing stop behind our individual stock recommendations.
They keep us from selling our stocks while they’re in a major uptrend – and prevent small losses from becoming unacceptable losses.
Occasionally, members ask why we use a 25% stop rather than a closer one. And why we base it on the closing price rather than the intra-day price, as we do with our VIP Trading Services.
Let’s start with the 25% policy.
Even when a stock is moving the right way, it will have good days and bad days. You want to keep your stop close enough that you’re protecting the majority of your profits (and your principal) and far enough away that you don’t risk getting stopped out by daily trading action during the uptrend.
Some disagree with our 25% policy. For example, William O’Neill, publisher of Investor’s Business Daily, recommends placing a stop 7% to 8% below your initial entry price. If you’ve tried this, you already know it doesn’t work.
Growth stocks are simply too volatile for a stop this tight to be effective. You end up getting stopped out so frequently you feel like you’re spinning your wheels.
(O’Neill insists that if you time your purchases correctly this shouldn’t be a problem. But there’s the rub. How can you time all of your purchases “right” when the market swings back and forth like a palm tree during a hurricane?)
For long-term investors, a 25% trailing stop is about right. Traders, on the other hand, will want to run them about half as far away because they’re gunning for short-term gains.
We also recommend that short-term traders base the stop on intra-day prices rather than closing ones. Why?
For starters, there are over 75,000 Oxford Club members. (There are much fewer VIP Traders.) It would not be a good idea to have 75,000 stop orders convert to market orders at the same time, for obvious reasons. That’s one reason why we base the sell recommendation on the closing price not intra-day fluctuations.
What happened last Wednesday with Clean Harbors (Nasdaq: CLHB) is another good reason.
A half hour before the market opened that day, Clean Harbors, the nation’s leading provider of hazardous waste management services, posted superb second-quarter results, beating expectations handily and raising guidance for the rest of the year.
But not long after the stock began trading, a sudden volume spike pushed the stock down and triggered our stop – even though the stock recovered fully (rising 15%) over the next hour.
This was odd, to put it mildly. It could be that someone dumped a large block of stock indiscriminately. But it also could have been Nasdaq market makers wreaking havoc by knocking down the stock only to run it back up again.
This shouldn’t happen. But, occasionally, it does. (The larger the company, the less likely this is to happen, by the way.) Anyone who has been trading long enough has seen it occur. And Clean Harbors is no easily manipulated penny stock. It has a market cap of almost $2 billion.
As an investor, what can you do to protect yourself from this?
If you have the time to keep an eye on your stocks, you can watch them closely and enter a market order to sell only if your stock breaks through a certain level for a given period of time. That way your order is not out there where traders or unscrupulous market makers can pick it off.
But what do you do if you’re running a business, or playing golf, or traveling? After all, a stock can go through a stop like a hot knife through butter. By the time you realize it’s below your stop price, the stock could be significantly lower.
For this reason some investors – perhaps most – are better off using an actual stop order, rather than a so-called “mental stop.” Most of us don’t have time to watch our stocks from 9:30 a.m. to 4 p.m. five days a week.
Weigh the pluses and the minuses of entering stop orders versus using a mental stop and using intra-day or closing prices.
Whichever way you go, the important thing is to have a sell discipline and stick with it. Without a sell discipline, emotions come into play. And emotions are almost always wrong.
The best investors are unemotional investors.
Alexander Green
Market Watch
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