Like the 200-day moving average (200 DMA) strategy, a stop-loss sell strategy takes the emotions out of trading by setting a predetermined sell point. But where the 200 DMA applies to the entire market, a stop-loss strategy is concerned with an individual investment. It helps you determine when to sell a specific stock, that is, when to “stop losses” on that investment.
When using a stop-loss, you decide upon a certain price that you do not want to go below, and create an order to sell the stock if it trades at that price. As an example, let's say you bought stock from Pretty Good Company (PGC) at $1.00 per share, and after a few considerations (which we'll talk about later in the chapter) you decided to set your stop-loss at 90 cents. If Pretty Good Company's stock price fell below 90 cents, your stop-loss order would be triggered, and that particular investment would be sold at the next available price.
There are several versions of stop-loss strategies. I prefer the trailing stop-loss because it can help you to make a profit while protecting your investment.
The strategy is called a trailing stop-loss because the sell point rises along with (i.e., trails after) the stock price. If you bought Pretty Good Company's stock price at $1.00 and set your initial stop-loss at 90 cents, your stop-loss would be 10 percent. If you used the trailing stop-loss strategy and PGC's stock price rose to $1.10, your new stop-loss trigger point would be 99 cents, which is 10 percent less than $1.10, the new highest entry price. Your old stop-loss point becomes obsolete.
The trailing movement of the sell point can help you make a profit. It allows your stock to go up while protecting your gains. How? The exit point in the trailing stop-loss strategy only goes up. It never moves downward. By doing this, it helps you to limit your downside risk while keeping most of your profits. But, remember, this is a sell strategy. Once your stock dips below its trigger point, you have reached your risk tolerance level. You need to sell and preserve your money.
How do you decide your exit point for a particular investment? By determining how much risk you want to take, and considering the nature of the particular stock you are dealing with.
As you know, I think investors over 50 should be cautious. It's incredibly important to carefully calculate your risk tolerance, remembering that if you're not living off your investments now, you soon will be. How much risk do you want to take with your standard of living?
Cautious investors who use the trailing stop-loss strategy tend to use tighter parameters, but they also need to take the particular stock's behavior into account.
Once you have figured out the amount of risk you're willing to take, look carefully at the stocks with which you'll employ a trailing stop-loss strategy. Each stock has a different amount of volatility, and you need to recognize and understand its typical behavior before determining an exit point.
For example, Pretty Good Company's stock might be really stable, and hardly move at all. Given its low volatility, you could put a 5 percent stop-loss on it. If that seemingly super stable stock dropped 5 percent, it could be a good indicator that there was trouble ahead and it would be a good time to sell.
But let's say you also have shares of Newfangled High-Flying Corporation. As the brightest, shiniest, most exciting company around, it might rise 5 percent every day for a week, then drop by 5 percent on the next Monday after the CEO says something silly on Twitter. It might rise 30 percent the next day when he apologizes by giving a bunch of money to charity. If you put the same 5 percent stop-loss you used for Pretty Good Company on the stock for Newfangled High-Flying Corporation, you would end up selling it when it was just behaving normally. Instead, you would probably want to put a larger stop-loss on that stock; say 15 percent. That way, if it rose 30 percent and then dropped 15 percent, you would still preserve a 15 percent gain.
How do you learn about the behavior of a particular stock? You can look at that stock's beta, and/or its standard deviation (see Tables 19.1 and 19.2).
A stock's beta tells you how volatile that investment is in comparison to the market as a whole. A beta of 1 means that the stock closely follows the swings of the market. A beta of less than 1 tells you that the stock is less volatile than the market, while a beta greater than 1 means that the stock's volatility exceeds that of the market. In other words, a stock with a beta of .90 would generally be 10 percent less volatile than the market, and a stock with a beta of 1.1 would be 10 percent more volatile. As you can see in Table 19.1, more stable investments (like shares in Pretty Good Company) will have typically lower betas than riskier (and sometimes more profitable) stocks like Newfangled High-Flying Corporation.
Table 19.1 Comparison of Betas of Some Famous Companies
| Company | Beta |
| Aeropostale, Inc. | 1.84 |
| Buckle, Inc. | 1.08 |
| The Sherwin Williams Company | .59 |
| General Mills, Inc. | .15 |
| McDonalds Corporation | .28 |
| American International Group | 1.94 |
| Genworth Financial | 1.74 |
| Principal Financial Group | 1.86 |
| Hershey Co. | .20 |
| Walmart Stores | .45 |
| Family Dollar Store | .39 |
| Ford Motor Company | 1.60 |
| Prudential Financial | 1.69 |
| Metlife Inc. | 1.87 |
| The Coca-Cola Company | .48 |
https://www.google.com/finance.
Also known as historical volatility, the standard deviation calculates a stock's expected volatility in percentage terms by measuring the dispersion around an average. A high standard deviation indicates that the data points are spread out over a wide range of values; that is, the higher the percentage, the more volatile the stock (see Table 19.2).
Table 19.2 Comparison of Standard Deviation of Some Famous Companies
| Company | Standard Deviation |
| Aeropostale, Inc. | 1.93 |
| Buckle, Inc. | 3.56 |
| The Sherwin Williams Company | 3.02 |
| General Mills, Inc. | 3.93 |
| McDonalds Corporation | 3.85 |
| American International Group | 3.98 |
| Genworth Financial | 2.69 |
| Principal Financial Group | 4.31 |
| Hershey Co. | 6.87 |
| Walmart Stores | 5.16 |
| Family Dollar Store | 5.89 |
| Ford Motor Company | 2.67 |
| Prudential Financial | 8.71 |
| Metlife Inc. | 3.33 |
| The Coca-Cola Company | 2.92 |
www.investorpoint.com.
Let's put aside our fictional examples, and see how the trailing stop-loss strategy could have worked with a real-life stock.
During the dot-com bubble, technology stocks rose very rapidly, but were also very volatile. For example, Qualcomm went up 6,000 percent between 1995 and 2000. It also jumped up and down, and up and down, over and over. If you had owned Qualcomm and understood the nature of that particular stock, you might have put a 20 percent trailing stop-loss on it. If you had, you would have stuck with Qualcomm through its normal volatility. You would have stayed with it as it rose 6000 percent, and when it turned, you would have sold. Yes, you would have lost 20 percent from its peak, but Qualcomm went down 85 percent. You would have saved yourself from that loss, and enjoyed most of that fantastic gain.
Remember, though, for a retired investor, the important part of this strategy is not making a profit, but reducing the losses. Like the 200-day moving average strategy, the trailing stop-loss strategy puts a theoretical floor underneath your investment. It can help you feel secure about investing without losing large amounts.