I had some email exchanges with reader Bob, who responded with the ultimate question. Here’s what he had to say:
I am using a 7% trailing stop for all ETF’s. So far, none have hit the execution point. The one issue I am struggling with is when to take a profit.
For example, I have MDY up 25% and IVV up 10%. Usually, I wait too long, and the ETF heads south before I realize it. The trailing stop will take care of a market reversal.
How much profit is enough without being greedy?
Every investor has been there and faced the tug-of-war between fear and greed. Is the market going higher, or should I sell now and lock in my profits?
Since no one can predict what the market will do next, it follows that there is no clear cut right-or-wrong answer. That’s where your sell stops can be of assistance.
Let’s do a quick review as to the purpose of a trailing sell stop when used with trend tracking:
1. It limits our losses, in case the trade goes against us, and
2. It locks in our profits, if prices continue to rise until the trend ends, reverses and triggers our stop loss point.
In order to avoid playing the emotional yo-yo, when it comes to deciding whether to take profits or not, you have to hone in on #2.
You have an unrealized gain in MDY of 25%. Since MDY is a domestic index, the 7% trailing sell stop rule applies. That means, if MDY comes off its high by 7% or more, since you bought it, it’s time to sell and lock in profits.
That translates into a gain of some 18% or so. At that time, the markets may fall further, and you’ll be glad you sold. Or, the rally resumes, and you will be left behind, at which point you have experienced a whip-saw signal and have to either look for a new entry point or another opportunity.
The important part is that you have to be mentally prepared to be OK with either outcome, especially since there is no perfect answer. Investing is an endeavor surrounded by uncertainty. Always having a plan in place to deal with the vagaries of the market place will make it easier for you to handle whatever comes your way.
I have found that the use of trailing sell stops, despite the occasional whipsaws, takes the guesswork out of the decision making process and allows me to gain some means of control in an environment where most things are beyond my influence.
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