"The Two Most Profitable Secrets of the World's Greatest Investors" An Investment U White Paper Special Report

Here's How Our Trailing Stop Strategy Works

If you do hold onto a falling stock too long, the loss will often be far more than just 25%. And all it takes is one big loss to set an investor back for years.

Let's say you start off with $10,000. A year later you've made 25% ($12,500). Same for next year ($15,625), and the next ($19,530). But then after three years of 25% annual gains, the fourth year, you take a loss of 50%. It puts you back below where you started, at $9,766.

Now, let's say you had a 25% trailing stop during the year you lost 50%. You would have been stopped out at $14,648. Then during the following three years (when you again profited by 25% each year), your holdings would be $28,600 at the end of that entire seven-year stretch.

However, if you didn't have a 25% trailing stop in place, after the same seven-year period, you would only have $19,073, still below where you were prior to the 50% drop!

Over the seven years of this example, you'd be up 186%. That's an average return of over 26% per year, much better than you'd think. But pick your own example, and do the math. Look back at your own portfolio. You'll see that cutting your losses is the key to both getting good overall returns and avoiding lost years.

Examples from Our Files

This is best illustrated by some specific examples–real recommendations made by The Oxford Club. And fortunately, the tech run-up and subsequent meltdown provided substantial proof that limiting your downside gives you more capital to invest in your winners.

Let's begin with a look at Adobe, the innovative software company on the (then) booming Nasdaq that we enthusiastically recommended. It zoomed up, with no sizable price correction, for 10 straight months. The stock kept achieving new all-time highs. Along the way we kept adjusting upward our 25% trailing stop. Given that we bought in at $31, we kept locking in higher and higher profits. When the technology and communications sectors finally began to correct, Adobe corrected along with them. But thanks to our 25% trailing stop, the worst-case result for Oxford Club members turned out to be a profit of over 81%.

Contrast this approach to the "buy and hold" strategy. The Nasdaq high techs had an amazing run. But when they began to unravel, things got ugly in a hurry. Compare our profit of over 81% to the devastation that occurred among other high-tech stocks during the same 10-month span. Amazon was down 60%, Qualcomm down 63%, Intuit down 66%.

Several companies witnessed declines of as much as 90%, and the "buy and hold" crowd held all the way down. That's what can happen when you hold a stock investment with no exit strategy. That kind of loss is hard to recover from. Just look at the chart above, and you'll get a good feel for the kind of long-term damage just one bad stock can do to your portfolio. Hang on too long... and it could take years to recover your loss.

In reality, most investors who say they're buying and holding will in fact panic in a bear market, especially a long grinding one. We saw it graphically in 2000-2002–the last bear market. Don't let this happen to you: Use a smart exit strategy that lets you capture the majority of any profits–even a doomed one.

The System Is Not Fool-Proof

As good as the trailing stop concept is, it's not perfect. For one thing, in particularly volatile stocks, you can get stopped out at a price much worse than you had hoped for.

Take Microsoft as an example. As stories circulated that the Justice Department was proposing a court-ordered divestiture of the company, its shares experienced serious volatility. Before the ruling the stock was trading at $79. The next trading day, Monday, the stock opened at $67. Even if you had a $75 trailing stop in place you would have had to sell at $67 because that was the next available market price to execute the trade. Once a stop price is triggered, it becomes a "market price" sale, that is a sale at whatever the market will bear. Normally that won't be a big problem, but sometimes volatility can make your target price impossible to fill, as in the Microsoft example.

Domestic U.S. stock markets do not accept trailing stop orders. And for thinly traded stocks, they don't even accept "hard" stops. Exchanges outside the U.S. seldom accept any stop orders at all. (Trailing stops move constantly based on the stock price. Normal "hard" stops are put on at a particular price and remain regardless of what the stock does.)

Trailing stops are changed according to what the stock does–the higher it climbs, the higher the trailing stop is moved.

If exchanges won't accept these orders, there are two alternatives. Both are mental stops, either put on by you or by your broker. Either one of you–or both–must be on top of the situation–always.

Value Trading–When the Trailing Stop Might Work Against You in the Market

By its very nature, value trading can work against the trailing stop. Value trading–the system of buying strong companies at or near historical lows–implies that you may temporarily follow a stock down past a trailing stop before it begins to rebound. With a trailing stop in place, you may never see the rebound.

And this happened to us recently. We recommended Debt Strategies Fund as a good way to play the beaten-down, high- yielding corporate bond sector. At the time, it was priced around $7. But, more importantly, it was yielding over 16% annually, making it a perfect candidate for our Oxford Income Portfolio.

However, about nine months later, we came full circle with breaking stock market investment advice. We advised members to disregard our trailing stop for this investment. Why? Because at that time, Investment Director Alexander Green valued the income-producing yield more than the price-per-share dip. And he thought the chance for the fund to dive significantly below our trailing stop was remote. So, when the price dipped below our $5.80 trailing stop, we held on.

With no trailing stop strategy, there was no guarantee that we would stop losing money on this investment if the stock continued to slide. We might have lost 60%, 70% or even more. Fortuanately, the fund behaved like Alex thought it would. The price per share quickly rebounded to over $6 in just a few days. So we need to carefully consider value trades in light of the trailing stop.

JDS Uniphase: A Perfect Run-Up in the Stock Market

And now we've come to our quintessential example of the power of the trailing stop: JDS Uniphase. Even though the story is almost five years old, it defines the profit-making power of trailing stops like no other. In March of 1999 we heartily recommended JDS Uniphase. We said then that "it would be the company that would create the next great fortune," and it "is one stock investment that you don't want to miss."

We placed the normal 25% trailing stop on it.

It turns out this was sage advice, as the stock had a perfect, even breathtaking, run-up. It rose from our recommended price of $10.95 (split adjusted) to $110.12–a whopping 905.66% in 14 months. But amazingly, during that entire stretch, the stock never had a real pullback in the market. Without the 25% trailing stop strategy, it would have been tempting to sell some or all of it at 100% or 200%. Had we done that, we would have missed out.

When the stock reached $150 we were still in it, and subtracting 25%, the lowest price we would sell this stock would be $112.50. As it turned out too, $150 was the high point for the stock. Of course we didn't know this at the time, nor did anyone else. But that's the great thing about the trailing stop system–it takes the "guesswork" out of trying to determine a stock's value. We let the market tell us when the run is over.

The trailing stop system always keeps us from losing our shirt and always locks in our profits when a stock has had a significant gain. How many times have you heard of investors saying they made 100%, 200% or more–only to give it all back when the stock corrected? That's not happening with our system–sure, we may give back a little, but we're always locking in profits on our winners.

If JDS Uniphase had continued to rise above $150, we would have been along for the ride. But in this case, $150 was the top, and it gives one a great feeling knowing that even if the worst were to happen–a stock collapse–we would have a huge 905%+ profit. That's the beauty of the 25% trailing stop strategy.

The Rest of the Story–Don't Buy and Hold

JDS Uniphase also provides a dramatic example of the benefits of our system versus the perils of holding and hoping. As we said above, we took more than 906% profits from this investment. JDS was a grand slam for us.

Unfortunately, for investors who don't use a trailing stop strategy, JDS is also the perfect example of the "big fish that got away." From its high of more than $150 per share, the stock has plummeted. As of July 2004, JDS was trading at a little over $3.28 per share–that's about a 97% drop from the high. That's the power of a trailing stop strategy–it can mean the difference between taking more than 900% profits and losing 97% of your investment's value.

Use Daily Prices in Your Stock Market Investment Strategy

We use end-of-day prices for all our calculations, not inter-day prices. You should too. This makes things easier. If a stock has gone to $100, put a mental stop at $75. If, subsequently, the stock closes at or below that $75 level, sell your shares the next day.

The Oxford Club's web site features daily updates and posts on our recommendations. The instant one of our stocks triggers our trailing stop, we immediately post notification on the web, so that you can take immediate action. This means that you don't have to follow the stock yourself or worry about when you should sell.

Remember, the key is discipline. This is a good technique. Stick to it. Choose a broker who understands trailing stops and will do the work for you.

Stock Market Investment Advice You Can't Afford to Miss Out On

If you use a discount broker or trade on the Internet, there may be times when you are moving your stop up each day–even when you are on vacation (that's a great problem–it means you're making money). We know that most people need time away from the stock market to recharge their batteries. Each person has to decide whether it pays to go with a full-service stock broker who can run their investments for them. To help with this decision, we initiated our Oxford Club Safety Switch e-mail service. Now, any time one of our recommendations hits our trailing stop, we immediately alert our members via e-mail.

One thing about life is certain: You are never going to know the future. Nobody–even the most astute analyst or investment advisor–can know enough about a particular company, industry or the nuances of the stock market to anticipate with 100% certainty the future price of a stock.

But common sense dictates two investment fundamentals:

1) Taking small losses is much better than taking big losses. 2) Letting your profits run is much better than cutting them off prematurely.

Using trailing stops is the best first step you can take to greatly improve your portfolio's return. Follow this time-tested technique of the world's greatest investors and your investments will outperform those of your friends, neighbors and even your fund managers.

This is the first step to having a coherent, reliable system that will let you sleep at night and give you the satisfaction of knowing you're maximizing your profits.

Once you apply trailing stops, you'll be that much further ahead of the ordinary investor.

Now, you're ready to go to the next level in our 'Stock Market Investment Advice' White Paper–and learn the next secret of the world's greatest investors...

Secret #2: Go With "Low Risk"–And Then Let Your Winners Run

(See Part 3 of this white paper by searching this web site by Author's Name for ‘Steve Sjuggerud.’)