Thursday, July 4, 2013

How to Use a Trailing Stop - $ORCL

For small investors with self-directed brokerage accounts, there are automated tools to help mitigate losses, when 'the market' or a particular equity turns negative.  A Trailing Stop is one such tool.

Of course all investors are happy when the value of their investments are going up, generally watching that upward trend in the hope that it will continue!  Unfortunately, when ‘the market’ goes down, they sometimes run scared of taking losses and often, most unfortunately, sell their stocks at market lows, at a loss.

The primary reason for the behavior described above is emotion.  Secondary reasons include procrastination, greed, a lack of knowledge about investing, and more.

Since everyone is generally happy when his or her investments are posting gains, let’s focus on how small investors can mitigate downside risk.

One of the most useful tools I’ve seen (and use frequently) is Trailing Stop functionality offered via my self-directed brokerage account.  Trailing Stop is a fancy name for a ‘stop-loss’ order that trails an equity’s price.
According to Investopedia: “This is such a useful tool, yet many fail to use it. Using a trailing stop allows you to let profits run while cutting losses at the same time.”
By way of a practical example, let’s take a look at Oracle ($ORCL) at the time of their earnings release of March 20, 2013:
1.     For most of the earlier part of the month $ORCL traded in the mid-$30’s.
2.     After market close on 3/20, $ORCL announced financial results for Q3.
3.     Revenue for the quarter was $9 billion; non-GAAP EPS, 65 cents.  Analysts were expecting revenue of $9.37 billion and non-GAAP EPS of 66 cents.
4.     $ORCL had closed at $35.76 on March 20. In after hours trading, the stock hit $32.30 and by March 25th, $ORCL was trading at $31.25.

A year earlier $ORCL was trading at around $28.00.  Using the Investopedia “let profits run” analogy above, the return of a long position in $ORCL over one year (at the then current sales price of $36.00) would have been close to 30%.

An investor who bought $ORCL at $28 could have entered a Trailing Stop order at e.g. 3% (Trailing Stops can also be entered in dollar value instead of a percentage).  In simple terms, decide up-front how much of your investment you would be willing to lose.  

A ‘trailing stop-loss order’ of 3% would have followed (or trailed) the upward growth in the $ORCL stock price, that's why it's called a Trailing Stop.  If the stock priced dropped by about $1 (e.g. 3% of $35), the trailing stop order would automatically have become a market order, the position would have been closed at $34.00... and the investor would have cashed a gain of >20%.  Cash that becomes "cash awaiting investment."

Conversely, if an investor had bought $ORCL at $28, plugged in a 3% Trailing Stop, and the stock dropped shortly thereafter by more than 84 cents (3% of $28), the automated market order triggered by the Trailing Stop would have capped the loss, within a range that the investor had pre-determined to be acceptable, as suggested above.

When you invest, you do plan and determine upfront what amount of loss you are willing and able to accommodate... right?

Here's one caveat, and the reason why I chose $ORCL for my example.  If an investor had plugged in a Trailing Stop order of 3% and the stock dropped by 10% in after-hours trading, the Trailing Stop would have executed at the opening price the morning of the following business day, or $32.20, as above, actually executing at a price lower than the stop-loss price or percentage, e.g. 3%.

Therefore, if one had held $ORCL long for a year (bought at $28), even an after-market-hour closing price ‘crash’ of 10% would have allowed execution at $32 to cash/bank a profit of 14%.  Remember, no one has ever lost any money selling something for a profit, even a small profit!

An additional benefit of using a Trailing Stop order is that – more often than not – one is able to cash gains, allowing you to buy back into that same equity at the (now) lower price.  Because the investor avoided selling the stock at a loss, buying back into the same equity – while on sale – avoids the further cost of a ‘wash sale’, but perhaps that’s a topic for a future discussion. 

Happy trading, and best of success!

Here's a graph showing the history one year prior, courtesy YCharts: