One of the challenges of managing your own stock portfolio is deciding when to take your profits. An even bigger challenge is when you have a really good running stock on your hands and you don’t know how long it is going to run up. You don’t want to sell too soon and miss some money, but you don’t want to try to guess a top — and it will be a guess — and then take a big hit when it comes down. Like him or not, Jim Cramer makes a good point in that bulls make money, bears make money and pigs get slaughtered. In other words, don’t try to get too greedy or you will find all your profits going down the tube.

How to protect your profits

So just how do you protect that great running stock? One surefire way to keep your emotions out of the equation and protect your profits is by using a trailing stop. To put it simply, a trailing stop lets you set either a dollar amount or a percentage amount that will follow or trail, the stock price and if the price comes down to that point a sell order is triggered automatically for you. This kind of order is quite common for those that trade commodities and forex, but not quite as common for regular stocks.

Note: A trailing stop does not guarantee that your order will be executed at that specific price point. While in practice it does, market conditions may be such that your order isn’t execute on exactly the same price. What kind of conditions? A really fast moving market, such as a crash or a really volatile market.

Where to set your stop

This is the $60,000 question (figuratively speaking of course :). Where you set it depends on how much the stock has moved already, how much you anticipate it to move and how much volatility you are willing to accept. As for myself, I use a percentage trailing stop of about 5% to 8%, leaning more towards the 8% mark. At 8%, I give the stock the opportunity to weather a minor correction (jargon for sell off) and keep moving up without getting stopped out too soon. The more a stock has moved up also plays a little bit into my equation as well.

The nervous zone

In the 10%-15% range I will keep it a bit closer to 5%. Why? Well 10%-15% gains in a stock is pretty good sweet spot to sell, and most people will. What can happen is the market will start to take profits around this price point which of course can drive the price down. If the stock is really good, it will either not drop or the drop will be very short term, say a day or, as the big players — namely mutual funds — buy into that sell off and that will drive the price back up, hence the nervous zone. To put it another way, at 5% I can take a small correction, but will lock in a 5% to 10% gain on my trade without the risk of losing all of my profits if the stock doesn’t recover quickly and continue to move up. The 5% to 10% gain comes from taking the 10%-15% gain minus the 5% trailing stop.

Show me the money zone

If it does recover quickly and move beyond 20%, then I’m more willing to give it some leeway, since at 20% I’m locking in a 12% gain (20% minus the 8% trailing stop). This is the spot where we would like all of our trades to be! At this point you’ve already made a really good gain at a minimum of 12% and are letting the stock ride. You aren’t worried about trying to spot a top or do any other kind of fancy analysis to wring out every last penny of profit. Yes, yes you are effectively “losing” 8% when your trailing stop does get triggered, but don’t think about it as losing anything. You’ve already gained 12% and who knows how much more, so losing that last 8% isn’t really losing anything at all.

Before you ask, yes there are occasions when a stock will make a larger than 8% correction, you will get stopped out, then it turns back around and keeps going up. It has happened to me and frankly I don’t worry too much about it. OR, I take my profit, and put some back into that stock IF I believe that it has at least another 10% percent to gain. You won’t find that often because if you think about it, that is a gross gain of 30% on the stock. So you only got 12, 13, 14% or whatever on it. Is that such a bad thing?

Do I ever diverge from this?

Yes, there are occasions when I will get to a 20% gain and not put a trailing stop in and just sell it at that point. Those occasions are:

• I have another stock lined up waiting for funds. I’m happy with this stock’s performance and I’m ready to get into another one.
• The 20% gain came after 8 weeks of holding the stock. A stock that goes up 20% in under 8 weeks is likely to be a strong performer, so if my gain took, say 12 weeks, the chance of it running far beyond that aren’t as great and I’m ready to take my profit.
• I’ve bought the stock twice and I take some profit off the table and let the rest ride. I’ll cover this more in a later post, but suffice to say it is a good idea to take some profit while you have it and risk less for that bigger gain.

An Example

OK, so to see a quick example of how this works, I will use a stock that I own as of this writing. The stock is Research In Motion Limited (RIMM). As of the close of 9-19-2007 it is at $91.80 and I have an 8% trailing stop. That means that if the stock tanks tomorrow it will sell automatically at $84.46 ($91.80 - 8% = 84.456. I rounded up). I bought RIMM at $71.67 so my net gain would be 17.85% (yes I factored in trading fees).

However, perhaps RIMM goes up another 1.6% as it did today. That means the closing price would be $93.27 and my trailing stop would now automatically be set to $85.81 and it starts all over again.

Remove the emotion

So by using a trailing stop you can go about your day and not worry too much about watching your stock on a daily basis trying to determine if it is close to a top and decide if you should sell or not. You also remove the emotional aspect of wanting to hold a stock that goes down too far waiting for a comeback. When it goes down to your stop, it sells and you move on.