Common sense would dictate that any investment approach should incorporate some kind of an exit strategy but, unfortunately, most investors and advisors have not caught on to that simple bit of investment wisdom.
From time to time, readers email me with comments on the implementation of sell stops. Let’s take a look at what Paul had to say:
I’d appreciate (and perhaps other readers as well) your expanding on the use of stops. I currently put them in place on any position with an ETF or stock since I cannot watch the market. Have you done any testing (like with your hedging strategy) that indicates using end-of-day close and some type of exit the following day is better than keeping a stop order on the books?
The idea is to follow the signals as they occur. I treat ETFs the same way as I do mutual funds in that I base my sell decisions on day-ending closing prices only. Intraday volatility can otherwise stop you out prematurely. This is not an exact science, nor a matter of right or wrong, but simply one of preference.
When a closing price hovers around a sell stop point, I may give it another day to see if the trend moves back up or if it clearly pierces my intended stop point to the downside. In other words, I am introducing a little bit of subjectivity to avoid a possible whip-saw.
Another reader commented as follows:
I appreciate your thoughts on exit strategies. Being at work during market hours, I’ve often relied on sell stops, which I reset based on closing prices. Granted, they’ve sometimes thrown me out of positions at inopportune times, but they’ve also saved some profits and limited some losses.
If I switched to alerts and submitted market sell orders before the next opening bell, the opening volatility could hurt since I couldn’t be sure what price my shares would bring. It’s too bad that I can’t delay submitting morning trades until the market has opened and settled down.
Again, when a sell stop has clearly been triggered, the goal is to follow it and get out of the market. It does not matter whether there is opening price volatility or not; there is no need for you to attempt to do some scalping in order to save a few dollars.
Keep the big picture in mind, which is to follow long-term trends until they end. When markets reverse direction, you’ll never know ahead of time whether that reversal can turn into a disaster with lightening speed such as it did last year.
On the other hand, a whip-saw signal is always a possibility. However, I consider such an event as simply cheap insurance to guard against major portfolio destruction such as we’ve seen in 2008.