A little over 12 months ago I wrote several articles on the use of trailing stops to help manage stocks in your portfolio. The article referred to the use of a simple 3 ATR trailing stop, which simply measures the average true range of the stock over a specific look back period, (days, weeks or months) and in this case I used 21 weeks. This type of look back period tends to suit most medium to longer term investors. The simple risk management rule suggested at the time was to close out of your positions (sell) should the stock’s closing price fall below its 3 ATR trailing stop. This type of rule has shown over the longer term to be very good at helping investors manage their trades as it allow plenty of room for a stock’s price to fluctuate whilst still providing a simple exit strategy. The beauty of the trailing ATR based stop is that it follows or trails the stock’s upward progression helping to protect profits along the way. (Unless you don’t take action when you should.)
Below is an image of the ASX200 index, tracking the performance of the top 200 stocks on the Australian market. The red line is the trailing 3ATR. In June of last year you will notice that the price of the ASX200 closed below this line. What was this telling us at the time and how can we interpret this information? The ASX is a measure of broader market performance and so not every stock in the index will necessarily be performing poorly. A simple way to check would be to look at the chart of each stock in your portfolio to see where it is in relation to its trailing stop. Nevertheless, with the ASX200 falling below its trailing 3ATR stop in June last year, and the XAO (All Ordinaries index) falling below its in September of last year, the charts were telling us something; Market risk was increasing.
Now just because overall market risk is increasing doesn’t necessarily mean we should be running for the hills. It simply means that you need to be vigilant in monitoring your portfolio because as the broader market starts to struggle it may start to impact specific stock holdings. For investors of with a medium to longer term outlook this style of trade management works well because it doesn’t require daily monitoring, just a quick look at the end of each week to see if you need to take any action or not. For those of you without an investing plan the chart above may well be the starting point or foundation of creating one that is simple and importantly, easy to follow.
David McCulloch is a market educator and consultant to Share Wealth Systems.