4) Buy put options
Buying put options is a more sophisticated variation of a trailing stop that gives those who use it more control over the sales process. The drawback is that the cost of your investment goes up because you’re effectively buying “insurance” against a loss.
For instance, if you bought 100 shares of Facebook (NASDAQ:FB) today at $20 and wanted to limit your losses to 25% of your purchase price, you could place a trailing stop at $15 a share. Your initial investment would be $2,000 (ignoring commissions and fees for the sake of simplicity) and you’d be selling your shares automatically if the stock dropped to that point.
Or, you could buy 100 shares of Facebook today at $20 and simultaneously purchase a November $15 put for $0.70. Your initial investment would then be $2,000 plus the cost of the option or $2,070 (again ignoring fees and commissions).
As the price of Facebook shares drop, the price of the put option you’ve purchased goes up, helping offset the loss you would otherwise be incurring. If shares of Facebook rise, the value of the put option generally drops.
If Facebook is trading above $15 on November 16, 2012 when the put option in this example expires, you lose the $70 and you’ll have to buy another put option to “protect” your investment further, which means your cost basis goes up again.
If Facebook is trading below $15 on November 16, 2012, the option goes “in the money” and helps limit your loss to the difference between your purchase price of $20 and the strike price of the put option which, in this case, is $15 (excluding fees and commissions for simplicity’s sake).
On a related note, some people like to sell call options against their stock as a means of offsetting losses incurred as a stock drops.
While I can understand the merits of doing so, I’m not a big fan of this strategy because it’s very hard to sell enough options over time to pay for the loss associated with a given investment particularly if there’s a catastrophic move to the downside, especially under current market conditions.
5) Set profit targets
I’ve saved the best for last. It’s setting simple profit targets.
Like trailing stops, profit targets are usually set in percentage or dollar terms.
I’m a big fan of profit targets because they offer an unemotional path out of the market and ensure discipline no matter how emotionally attached I become to a particular investment.
Unlike many investors who constantly shoot for the moon, I don’t see the need to be greedy. Depending on my expectations and market outlook, I’ll set realistic profit targets that can vary widely.
For conservative choices, 10% over a few months might be good. For more aggressive recommendations, banking more than 100% in only a few weeks or even days may be appropriate.
Either way, if and when an investment hits my price target, I’ll sell with no questions asked and bank the gains. I almost never look back.
Many investors like to think they’ll do this but, in reality, find that they get sucked into the moment because they confuse the potential of additional upside with very real need to manage the risks associated with staying in the game longer than they have to.
You might think this is not a big deal. I beg to differ – any time you attempt to second guess the markets you are, in effect, introducing a timing element into your decision making process. That’s one of the most costly errors you can make.
As I noted earlier this summer, trying to time the markets is an exceptionally bad idea – 85% of all buy/sell decisions are incorrect, according to Barron’s.
Further, the latest Dalbar data shows that the return of an average investor trying to time the market is a pathetic 1.9% per year versus the S&P 500 return of 8.4% over the same time period. Over 20 years, that’s the financial equivalent of taking a 342% hit in lost performance.