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The Value of Using Trailing Stop Orders: A How-To.

Byline: Mike Patton

In April 2013, my custodian, TradePMR, introduced trailing stop orders (TSO) to its advisors. In this post, I'll share some lessons I've learned about TSOs and discuss the importance they play in protecting a portfolio.

The markets of the past few years have been some of the most challenging I've ever experienced. Due to the actions of the Fed, cash is paying next to nothing and bonds are subject to the risk of rising interest rates. Stocks are one of the few remaining asset classes where an investor can garner a decent return. However, if you assume too much exposure, you are subject to much greater risk. How can you accept a larger allocation in stocks and keep your risk manageable? Trailing stop orders can help.

If you're unfamiliar with TSOs here's a brief refresher. TSOs are very similar to regular stop orders with one major difference. A securities TSO 'trails' the market price of the security when it rises and remains flat when it falls. As a result, your maximum loss is limited to the initial stop percentage you select on the TSO.

Therefore, establishing a prudent TSO percentage is crucial.

Unfortunately, outside of a high-level overview on TSOs, I couldn't find any detailed, empirical data on how to determine what percentage to use. In any event, here's what I've discovered about setting the percentage on a TSO.

The first step is to define the purpose of the TSO. This may differ slightly from one advisor to another. In my case, TSOs are not used to avoid a small correction. Rather, I use TSOs to avoid more serious losses. Hence, if the TSO percentage is too small, then even a small decline can trigger a sale.

To avoid this, simply raise the TSO percentage. The key question is determining exactly what percentage to select. In the past, I would routinely set my TSO percentage around 5.0% (+/-). However, I now use 8.0% to 10%.

How is it working? To explain, I purchased several ETFs during the recent October swoon. When the markets peaked on December 5, a little over a month later, I was up about 8.0% to 12% on these positions. Eleven days later on December 11 - after the market declined approximately 5.0% - the rebound began.

If I were still using the smaller TSO percentage, my positions may have sold and because the rebound was in the shape of a "V," I would have bought back in at a slightly higher level than the level at which I sold. Of course, to avoid the wash-sale rule, I would have bought different securities if any of those sold was at a loss.

This time, however, with the higher TSO percentage, even at the bottom, I was still about 3.0% to 7.0% above the original purchase price. The goal of avoiding a large loss was accomplished and I remained more fully allocated to stocks when the rebound occurred. There are also a number of strategies to consider on positions which have risen to capture profits. We'll look at those in a later post.

TSOs are a great way to protect the downside without surrendering anything on the upside. However, it's important to set your stop price at a level which will not cause a sale due to normal volatility.

Until next time, thanks for reading and I hope you have a great holiday season!

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Publication:ThinkAdvisor
Date:Dec 22, 2014
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