To maximize your returns, you do not only have to buy at the right time but you also need to sell at the right time. Trailing stops help to do the job.
For example, if you buy a stock at $20 and you’re using a 25% trailing stop, you immediately place a sell stop at $15. When the stock rises, you raise your stop accordingly. When the stock gets to $30, for instance, your sell stop is $22.50. When it gets to $40, your stop is $30.
Trailing stops do really work. They protect your profits and your trading capital. In a study published in The Journal of Portfolio Management, finance professors at the State University of New York at Albany Christophe Faugère, Hany A. Shawky and David M. Smith, researched the performance of money managers who oversee pension funds, endowments and high net worth accounts. As a result, institutional managers who fared best were those with restrictive rules that did not allow much leeway for hanging on to stocks for emotional reasons. The managers who relied on flexible sell strategies did far worse.
Sticking to a disciplined trailing stop strategy eliminates emotion-driven trading errors. It cures greed, overrides fear and it avoids wishful thinking. Trailing stops are not the only effective sell discipline but they’re one of the best and easiest to implement. They make sure you never let a small loss become an unacceptable loss and they keep you from selling stocks while they’re still in an uptrend.
Using trailing stops means you’re not just hoping that earnings grow and the market advances. You’ve taken out insurance in case anything goes wrong.
Sven Franssen