Proven Trailing Stop Strategies - Best Percentage To Use & Percentage to AVOID

Summary

In this episode of Market Trends, Matthew Carr, Chief Trend Strategist for the Oxford Club, discusses the importance of using trailing stops for investors to minimize risk and maximize gains. He explains how trailing stops work, providing a step-by-step example using Digital Turbine stock. Carr also shares insights from 10-year simulations, revealing that tighter stops do not yield better returns, and suggests that the optimal percentage for trailing stops varies based on the market cap and volatility of the stock.

Takeaways

• 📈 Matthew Carr, Chief Trend Strategist for the Oxford Club, discusses strategies for improving investment returns while protecting capital.
• 🎰 New investors often adopt a 'gambler's mentality', treating every stock as a potential lottery ticket, which is a high-risk approach.
• 🛡 Trailing stops are recommended as a risk management tool to prevent manageable losses from becoming destructive to financial independence.
• 🔢 A trailing stop is a dynamic sell order that activates when a stock's price falls below a certain level, which is set as a percentage of its peak price.
• 🐶 The trailing stop 'trails' the stock price, moving up as the price increases, similar to a dog on a leash.
• 💡 To set a trailing stop, calculate 75% of the entry price for a 25% trailing stop, adjusting it when the stock hits new personal highs.
• 📉 If a stock performs poorly, the trailing stop ensures that the loss is capped at the predetermined percentage, allowing for a strategic exit.
• 📈 In most cases, stocks will appreciate, and the trailing stop will rise, protecting more of the investment as the stock gains value.
• 📊 Carr's research indicates that the optimal trailing stop percentage varies based on the market cap and volatility of the stock, with no one-size-fits-all solution.
• 📉 Surprisingly, tighter trailing stops (15% or smaller) do not yield better returns and can lead to underperformance due to stocks' natural fluctuations.
• 📈 For large-cap stocks, 35% and 25% trailing stops performed best over a decade, while for small caps, 35% and 30% stops outperformed significantly.

Q & A

What is the main topic of the video script?

The main topic of the video script is about using trailing stops as a strategy to improve investment returns while protecting earned profits.

Who is Matthew Carr and what is his role?

Matthew Carr is the Chief Trend Strategist for the Oxford Club, and he is the presenter of the 'Market Trends' episode in the script.

What is considered a gambler's mentality in the context of the stock market?

A gambler's mentality in the stock market refers to an all-or-nothing approach where every stock investment is seen as either a potential fortune or a complete loss.

What is a trailing stop and how does it work?

A trailing stop is a type of sell order that is automatically triggered when a stock's price falls below a designated level, which is set as a percentage below the stock's highest price reached since purchase.

How does a trailing stop help in managing investment risk?

A trailing stop helps manage investment risk by capping potential losses at a predetermined percentage, thus preventing a manageable loss from becoming destructive and threatening financial independence.

What is an example of how to calculate a 25% trailing stop for a stock bought at $10?

To calculate a 25% trailing stop for a stock bought at $10, you would multiply the entry price ($10) by 0.75 (1.0 minus the trailing stop percentage of 0.25), resulting in a stop price of $7.50.

What happens if a stock's price continues to fall after purchase?

If a stock's price continues to fall, the trailing stop does not trigger a sale until the stock's price closes below the stop price, capping the loss at the predetermined percentage.

How should the trailing stop be adjusted as the stock's price increases?

The trailing stop should be adjusted only when the stock hits a new high for the investor. The new stop price is calculated by multiplying the new high price by the same trailing stop percentage.

What is the significance of adjusting the trailing stop only at new highs?

Adjusting the trailing stop only at new highs ensures that the stop price moves up with the stock's price, thus locking in gains and providing a dynamic loss protection level.

What is the best trailing stop percentage to use according to the script?

The best trailing stop percentage to use varies based on the market cap and volatility of the stock. However, the script suggests that tighter stops (15% or smaller) tend to produce worse returns due to stocks' natural daily fluctuations.

What insights did Matthew Carr provide from his 10-year simulations on trailing stop percentages for different stock sizes?

Matthew Carr's 10-year simulations indicated that for large cap stocks, 35% and 25% trailing stops performed best, while for mid caps, a 20% trailing stop was most effective. For small caps, 35% and 30% trailing stops outperformed significantly. A 10% trailing stop was the worst performer across all stock sizes.

Outlines

00:00

📈 Introduction to Trailing Stops for Risk Management

In this segment, Matthew Carr, Chief Trend Strategist for the Oxford Club, introduces the concept of trailing stops as a strategy for investors to protect their investments while maximizing gains. He explains that new investors often adopt a gambler's mentality, treating every stock as a potential lottery ticket, which is a high-risk approach. Carr emphasizes the importance of minimizing risk and removing emotion from investment decisions. He defines a trailing stop as a dynamic sell order that activates when a stock's price falls below a certain percentage of its peak, which moves up as the stock price increases, ensuring that losses are kept to a minimum while allowing for gains to be maximized. The explanation includes a practical example using Digital Turbine's stock, demonstrating how to calculate and adjust the trailing stop based on the stock's performance.

05:00

📊 Trailing Stop Percentages: Impact on Investment Returns

Matthew Carr continues the discussion on trailing stops by presenting the results of a 10-year simulation study that analyzed the impact of different trailing stop percentages on investment returns across various market capitalization sizes. He points out that the optimal trailing stop percentage is not uniform and depends on factors such as the company's market cap and the volatility of the stock. The study found that for large-cap stocks, 35% and 25% trailing stops performed best, while for mid-cap stocks, a 20% trailing stop was most effective. In the case of small-cap stocks, 30% and 35% trailing stops significantly outperformed the Russell 2000 index. Carr also highlights a counterintuitive finding that tighter stops, particularly those set at 15% or smaller, do not yield better returns and can lead to underperformance in the long term due to stocks' natural fluctuations. The segment concludes with Carr's reminder to adjust trailing stops only when a stock hits a new high for the investor, rather than daily, to avoid unnecessary work and maintain an effective strategy.

Keywords

💡Trailing Stops

Trailing stops are a type of trading order that allows an investor to set a price at which a security will be sold if it falls below a certain level, which moves with the market price. In the video, Matthew Carr explains that trailing stops are used to protect investors' profits and limit losses by automatically selling a stock when it drops to a predetermined percentage below its peak price. The concept is central to the video's theme of risk management in investing.

💡Gambler's Mentality

The term 'gambler's mentality' refers to an approach to investing where individuals treat stocks as if they were lottery tickets, expecting either a huge win or a total loss. In the context of the video, Carr warns against this mentality, suggesting that it can lead to significant financial loss and advocating for a more strategic and calculated approach using trailing stops.

💡Risk Management

Risk management is the process of identifying, evaluating, and controlling risks associated with investments. In the video, Carr emphasizes the importance of risk management by introducing trailing stops as a tool to minimize risk while maximizing gains, which aligns with the video's overall message of protecting one's investments.

💡Chief Trend Strategist

A Chief Trend Strategist is a professional who analyzes market trends and develops strategies for investment based on these trends. Matthew Carr, who introduces himself with this title in the video, discusses trailing stops as part of his role in guiding investors on how to improve their returns while protecting their capital.

💡Market Trends

Market trends refer to the general direction in which prices or returns of assets are moving in the financial markets. The video's title 'Market Trends' suggests that the content will focus on strategies and insights related to understanding and navigating these trends, with trailing stops being one such strategy discussed by Carr.

💡Financial Independence

Financial independence is a state where an individual has enough wealth to live without having to work actively for basic necessities. In the script, Carr mentions that not letting a manageable loss become destructive is crucial for protecting one's financial independence, highlighting the importance of trailing stops in achieving this state.

💡Emotion in Investing

Emotion in investing refers to the psychological factors that can influence investment decisions, often leading to irrational choices. Carr points out that one of the benefits of trailing stops is that they remove emotion from the investment process by setting a clear, objective rule for when to sell a stock.

💡Sell Order

A sell order is an instruction to a broker or trading platform to sell a security. In the context of the video, a trailing stop is described as a type of sell order that is triggered when a stock's price falls below a certain level, demonstrating how sell orders can be used strategically in investment management.

💡Volatility

Volatility refers to the degree of variation of a trading price series over time. Carr explains that the choice of trailing stop percentage should consider the volatility of the stock, as more volatile stocks might require wider trailing stops to avoid being stopped out too early due to normal market fluctuations.

💡Portfolio

A portfolio is a collection of financial assets such as stocks, bonds, commodities, cash, and cash equivalents, which may be held by an investor. In the video, Carr discusses the performance of different trailing stop percentages on portfolios over a 10-year period, emphasizing the importance of tailoring trailing stop strategies to the specific characteristics of one's portfolio.

💡Performance

Performance in investing refers to the return or profit generated by an investment or portfolio. Carr uses the term 'performance' to compare the effectiveness of different trailing stop percentages, noting that tighter stops do not necessarily lead to better performance and can actually result in underperformance over the long term.

Highlights

Matthew Carr introduces the concept of Trailing Stops as a method to protect investments from significant losses while maximizing gains.

Investors often have a gambler's mentality, treating stocks as all-or-nothing propositions, which is a risky approach.

Trailing stops are sell orders triggered when a stock's price falls below a designated level, helping to minimize risk.

Unlike a hard stop, a trailing stop moves up as the stock price increases, acting like a dog on a leash.

Setting up a trailing stop involves calculating a percentage of the entry price to determine the stop level.

An example is given using Digital Turbine shares, demonstrating how to apply a 25% trailing stop.

If the stock price falls, the trailing stop ensures a maximum loss of the predetermined percentage, capping the downside.

As the stock price rises, the trailing stop adjusts upward, locking in gains and reducing potential loss on a downturn.

Adjusting the trailing stop should only occur when the stock hits a new high for the investor, not daily.

Simulations over 10 years show varying trailing stop percentages perform best depending on the market cap of the company.

For large cap stocks, 35% and 25% trailing stops were the best performers, doubling the portfolio's gains.

Mid cap stocks saw the best performance with a 20% trailing stop over the past decade.

Small cap stocks had excellent returns with 35% and 30% trailing stops, outperforming the Russell 2000.

A tighter stop does not produce better returns; in fact, it can lead to underperformance, especially with stops of 15% or smaller.

The takeaway is that the choice of trailing stop percentage should be based on the company's market cap and stock volatility.

Matthew Carr emphasizes the importance of not letting emotion drive investment decisions and the role of trailing stops in removing emotion from the equation.

The episode concludes with an invitation to sign up for Matthew Carr's free e-letter for more investment insights.

Transcripts

- Today I'm gonna cover a topic,

I most often received questions about,

and I'm gonna give you a couple of simple tricks

to improve your returns,

while protecting what you've already earned.

(upbeat music)

Hi, I'm Matthew Carr Chief Trend Strategist

for the Oxford Club

and welcome to this week's episode of Market Trends.

New investors tend to have

a gamblers mentality to the market,

and by that I mean it's an all or nothing approach.

Every stock they buy is either gonna be a lottery ticket,

that means a fortune, or it's going to go to zero.

Well, that's the quickest and easiest way to go broke.

So for years, I've recommended one of the ways

investors can protect themselves

is to use something called Trailing Stops.

Essentially, you don't wanna let a manageable

or acceptable loss become something destructive

or ultimately threaten your financial independence.

You wanna minimize your risk while maximizing your gains.

And trailing stops let you do that exactly,

while at the same time removing emotion completely

from the equation.

So, what is this magical thing?

(orchestral music)

A trailing stop is a sell order

that's automatically triggered when the price of shares

fall below a designated level.

And this level is set by a percentage either,

15%, 25%, 35%, 42% if you're a Douglas Adams fan,

whatever you want.

But unlike a hard stop, a trailing stop,

moves up as the price of shares moves higher

it trails along behind it, maybe like a dog on a leash.

(dog growling)

So let's talk about a real life example

and go through this process.

For instance, let's say you bought shares

of Digital Turbine at $10.

This is a company I like

and you want to use a 25% trailing stop.

Well, how do you set that up?

It's really, really easy.

You're gonna take $10 your entry price, times 0.75.

This is determined by 1.0 minus

whatever trailing stop percentage you want,

in this case 25.

So 1.0 minus 0.25 gives us point 0.75.

So $10 times 0.75, equals $7 and 50 cents.

I know that sounds like a lot of math,

it seems super complicated, but it's really pretty simple.

Now, let's say Digital Turbine we bought at $10.

There was a complete dud,

it did nothing but fall since we bought it.

Well, we would sell automatically

when shares closed below that $7.50 level.

That means we would recap our loss at 25%.

And then we sell it,

we move on to greener and better pastures.

But in 99.999% of cases, that's not gonna happen.

A stock is gonna move higher

and as it hits new highs for you,

not new 52 week highs or new all time highs,

though those can be the same,

that trailing stop is going to move up.

So for instance let's say,

shares of Digital Turbine close at $10 and 53 cents.

Well, now your trailing stop moves up

that's a new high for you.

You take $10 and 53 cents times 0.75,

you get $7 and 90 cents.

So now, if shares close below that $7 and 90 cent level,

you'd sell and your loss is now capped at 21%.

So forth and so on,

but remember you're only re-adjusting your trailing stop

when shares are hitting a new high for you.

A lot of people that are new to trailing stops,

they'll do this adjustment every single day

and you're just making way too much work for yourself.

You only need to do this

every time it hits a new high for you.

So it's not gonna be every day unless you're lucky

and it just goes straight up to the moon.

Now for the difficult question.

This is the one that I'm asked most often.

What is the best trailing stop percentage to use?

Well, here, it's a whole bunch of asterixis.

You know, from my years of experience and research,

I found that the percentage of trailing stop

that you're going to use is gonna be based

not only by the market cap of the company

that you're investing or trading in,

but also the volatility of that single position.

So there's no real uniform answer, it's going to vary.

So to illustrate what I mean,

I'm gonna show you some 10 years simulations I ran.

And these are for different size stocks,

and then for different trailing stop percentage levels.

So for large caps,

these are the biggest companies in the market,

we see that 35% and 25% trailing stops,

were the best performers.

This portfolio base gains 200% or more

for both of those trailing stop levels over the past decade.

So that was extremely good.

Your 10% trailing stop level was your worst performer

even though it did more than double.

And for mid caps, we see that a 20% trailing stop,

resulted in the best performance over the past 10 years.

But I do wanna point out that that 10% trailing stop level

was the worst performer by a very significant margin.

And now let's look at small caps.

Here we see that a 35% and 30% trailing stop,

resulted in excellent returns.

In fact, these are using a 30% and 35% trailing stop

on small caps over the past 10 years outperformed

the Russell 2000 by a pretty significant margin.

But I also wanna make a note that 10% trailing stop

was by far the worst performer.

So what's our big takeaway here?

Well, first and foremost that your trailing stop

will vary a little bit from the size of the company

that you're investing or trading in.

That's something to kind of keep in the back of your mind

and kind of look at.

But most importantly, the big, bold, bright light takeaway

that's also kind of counterintuitive,

is that a tighter stop doesn't produce better returns.

It actually produces worse returns,

especially anything 15% or smaller.

That's because stocks will have a tendency to move 10%

or even 5% in a single day and if your stop is too tight,

you're not protecting your profits,

you're actually ensuring

that you're going to underperform over the long term.

I'm Matthew Carr,

Chief Trend Strategist for The Oxford Club.

Thank you for watching this episode of Market Trends.

For more information like this,

be sure to go down to the description

and sign up for my free e-letter.

Until next time, here is the high returns.

(upbeat music)