How to Lock In Profits on Every Trade

Richard M. Smith, PhD

B.A. Mathematics

University of California at Berkeley

PhD Systems Science

Watson School of Engineering, SUNY Binghamton

Doctor of Uncertainty

Currently consulting for Pfizer, J&J, Stansberry

Research, Oxford Club, etc.

My Investment Career• An inauspicious beginning• The beginning of TradeStops.com

Presentation Objectives

• Show you the most important thing that

investors can do to improve their returns.

• Show you what trailing stops are and how

they work.

• Show you how TradeStops.com works.

• Preview new features in TradeStops 2.0.

Which do you prefer?

Bet #1

•A: 80% chance to win $4,000; or•B: 100% chance to win $3,000

Which do you prefer?

Bet #2

•A: 80% chance to lose $4,000; or•B: 100% chance to lose $3,000

Common Obstacles to Success

i.e., why you might want to consider

something like trailing stops …

Those That Have Gone Before Us

The investor’s chief problem—and even his worst enemy—is likely to be himself.

Benjamin Graham

There is one important caveat to the notion that we live in a new

economy, and that is human psychology… which appears essentially

immutable.

Alan Greenspan

Terrance Odean and Brad BarberHaas School of Business, UC Berkeleyhttp://faculty.haas.berkeley.edu/odean/

Major academic studies on the behavior of

individual investors …

Hard Evidence from Barber and Odean

• According to a study of 88,000 investors,

“people are one and-a-half times more likely to

sell a winning stock than a losing stock, and the

losing stocks they do cling to under perform the

winners they sell by an average of 3.5%.”

Hard Evidence from Barber and Odean

• A study of 10,000 investors by the University of

California’s Graduate School of Management

similarly finds that the two most common

mistakes investors make is that they

“disproportionately hold onto their losing

investments and sell their winners too early.”

Hard Evidence from Barber and Odean

• In Nov. 2006, universities from around the world

jointly analyzed ALL trading activity on the

Taiwan Stock Exchange (TSE) and found that

investors are about “twice as likely to sell a stock

if they are holding that stock for a gain rather

than a loss.”

Barber & Odean (UCB) – Boys will be boys

Important Research Conclusions

• “Investors in our studies:•Traded too actively;•Were under-diversified;•Clung to their losers; and•Bought the stocks that happened to grab

their attention.”

Barber & Odean (UCB) – Boys will be boys

Important Research Conclusions (cont)

• Investors were motivated by:•Overconfidence• the desire to avoid regret, •and the difficulty of evaluating

thousands of investment alternatives.

Positive Prospects (Gambles)

Prospect #1• A: 80% chance to win $4,000• B: 100% chance to win $3,000

Expected Value• A: $3,200• B: $3,000

Percentage of individuals that prefer:• A: 20%• B: 80%

For gains we want the bird in hand.

Negative Prospects (Gambles)

Prospect #2• A: 80% chance to lose $4,000• B: 100% chance to lose $3,000

Expected Value• A: - $3,200• B: - $3,000

Percentage of individuals that prefer:• A: 92%• B: 8%

For losses … we’ll keep two in the bush, thank you.

Prospect Value or Utility Function

• We’re more willing to let go of the gains than we are to let go of the losses.

• The gains aren’t as important to us. In a strange way, we actually prefer the losses.

• So, if we hold two stocks – one a winner and the other a loser – and we need to sell one, which one are we going hold on to?

• The loser!

• We must reverse this pattern!

What it takes to get even after a big loss

Percent fall in share price Percent gain required to get back to break even

10% 11%

20% 25%

50% 100%

75% 300%

90% 900%

The Power of Compounding Interest

Behavioral Finance and Cognitive Biases

• The Bandwagon Effect: It must be the right thing to do because

everyone else is doing it. Bubble trouble!

• Loss Aversion: Prefer avoiding losses more than making gains.

• Outcome Bias: Judging a decision by its outcome rather than the

quality of the decision at the time that it was made.

• Sunken Costs : Money that has already been spent is more

valuable than money that may be spent in the future. If I sell at a

loss, I’m wasting money. Not!

• Recency Bias: Weighting recent data more heavily than earlier

experiences.

Behavioral Finance and Cognitive Biases

• Anchoring: Rely too heavily on readily available information when

making a decision. CNBC anyone?

• Belief in the Law of Small Numbers: Making mountains out of

molehills.

• Endowment Effect: Valuing something more once we own it.

• Disconfirmation Bias: Critical of information which contradicts our

beliefs while uncritically accepting information that is in line with

them. Hear what we want to hear.

• Post Purchase Rationalization: If a decision needs to be

rationalized after the fact it is probably wrong!

Goldman Sachs 2Q09 Earnings

Houston, We’ve Got a Problem!

• We’re biased against selling our losers and holding our

winners.

• We have other cognitive biases as well.

• It’s difficult to recover from losses.

• Compounded interest is looking pretty darn good.

• Goldman Sachs is taking the other side of our trades.

• What’s the solution?!

Trailing Stops

The simplest and most intuitive method for

reversing the tendency to hold on to your

losers and sell your winners.

Trailing Stop Example – JDS Uniphase

Trailing Stop Example – JDS Uniphase

What is a Trailing Stop

• Set a stop-loss a fixed percentage below your initial

purchase price. If you bought at $100 and you are using

a 25% trailing stop then your stop starts at $75.

• Check each evening if the latest close is below your stop

or if a new high has been made.

• If your stop was penetrated then close the trade.

• If a new high was made then adjust the stop. If the new

high is $102 then the stop is 0.75 * $102 = $76.50.

Trailing Stops beat professional judgement

Why We Love Trailing Stops

• Sophisticated enough to do the trick of cutting

losses and maximizing gains.

• Simple enough to be understood by all

investors.• Understanding gives confidence in heat of a

crisis.

• Used by world-class investors and traders.

• Failure to plan is a plan to fail. You’ve got to

have a plan!

TradeStops.com

Trailing Stops Only Service

Trailing Stops Only Service

TradeStops.com

TradeStops.com

Alerts can be organized into Portfolios

Email Alert Format

Trailing Stops Only Service

Trailing Stops Only Service

TradeStops Complete – Price Triggers

TradeStops Complete – Time Triggers

TradeStops Complete – MA & Volume Triggers

Benefits of TradeStops.com

• Tracks your trailing stops for you.

• Can track other alert types for you as well.

• Adjusts your alerts for dividends and splits.

• Covers US equities, Canadian equities, London equities,

US Mutual Funds, US indices, Foreign indices, Options.

• Alerts never expire – can be left open indefinitely.

• Stops are never visible to anyone even remotely

affiliated with the market makers.

• Great things to come …

What about my online broker’s trailing stops?

Online Brokers – TD Ameritrade

Online Brokers – TD Ameritrade

Trade Triggers™

Trade Triggers are essentially a set of "if/then" rules you craft to instruct

TD Ameritrade to automatically enter an order in your account or

send you an email alert as soon as a specific market event occurs.

TradeStops vs. Online Brokers

• TradeStops lets you leave an alert active for as

long as you are an account holder. Online

brokers make you cancel them after 60 days.

• TradeStops adjusts alerts for dividends and

splits. Online brokers cancel alerts after

corporate actions.

• TradeStops will never execute an order for you.

• TradeStops is simple to use.

TradeStops 2.0

TradeStops 2.0 – Main Navigation

TradeStops 2.0 – Alerts Only

TradeStops 2.0 – Alerts by Position

TradeStops 2.0 – Positions Only

TradeStops 2.0 – Closed Positions

TradeStops 2.0 – Closed Positions

TradeStops 2.0 – Closed Positions

TradeStops 2.0 – Portfolio Overview

TradeStops 2.0 – Portfolio Charts

TradeStops 2.0 – Research Charts

TradeStops 2.0 – Position Size Calculator

TradeStops 2.0 – Event History

Conclusions …

How to Lock in Profits on Every Trade?

• Learn to cling to your winners!

• Use a tool like trailing stops to help you to avoid

the tendency to hold losers and sell winners.

• Staying in your winners is HUGE. Often it is

even more difficult to than cutting your losses.

• Have a plan (navigate “the dip”).

• Remember that YOU are part of the equation.

• Use a service like TradeStops.com!

Markets Have Risk – We aren’t the only ones!

I can calculate the motion of heavenly bodies but not the madness of people.

Sir Isaac Newton

Our sector concentration is predicated on blackjack and investments.

Professional blackjack is being played in this trading room from the

standpoint of risk management, and that ultimately is a big part of our

success.

Bill Gross

The game of professional investing is intolerably boring and

overexacting to anyone who is entirely exempt from the gambling

instinct; whilst he who has it must pay to this propensity the appropriate

toll.

John Maynard Keynes

The Serious Self-Directed Investor