Too many investors have been advised that a policy of buy and hold is the best way to invest for the long run. The advice is typically: “Just buy a good stock and hold on as long as you can. The market will take care of you.” Well, the stock market has not been taking care of investors for quite a few years now. Instead, the market is taking stock investors on a wild stomach-churning ride—and there is no telling where it will end. Investors are getting sick along the way and are unsure that there will be anything left when the ride is over.

Buy and hold is failing as an exit strategy because it encourages a wait-and-hope outlook among investors and does nothing to provide badly needed control of gains and losses. Buy and hold may not be dead as an exit strategy, but if it’s not dead, it should be on its way to a better life somewhere far from these volatile markets.

The most obvious problem with buy and hold is that it is not a strategy at all. It is, in fact, the absence of any logical plan to protect profits and limit losses. A buy-and-hold approach sacrifices any semblance of control and relies on luck and hope rather than planning and control.

Back when the stock market was less volatile, a buy-and-hold approach was less stressful, and the decision to buy and hold was reinforced by a rising market that masked the fatal flaws that are inherent in the “sit tight and cross your fingers” school of investing. Record-high levels of volatility have clearly exposed the critical flaws of holding in spite of market conditions.

Buy-and-hold investors are now wishing they had followed better advice. The advice that they really needed to hear was “Get your head out of the sand and take control of your exits!”

Like most simple sounding investment advice, taking control of exits is much easier said than done. However, the rewards are well worth the effort. Gains on winning stocks will be locked in, and losses on bad investment choices will be limited. Investing will become a much more rewarding journey, and investors will enjoy peace of mind along the way.

Unfortunately, investors never have as much control over their investments as they might like, so we must ensure that they strictly control what is in their power. For example, if an investor bought shares of John Deere at $40 in 2006. It’s now early in 2008 and the shares have more than doubled as they approach $100 (see Figure 1). Can he or she control the price of the shares and implement some strategy that will make the shares go to $120 for an even bigger gain? Obviously not.

Investors have absolutely no control over the upside price action. The investor has to accept and protect whatever profits the market gives him or her.

If the stockholder is unable to control the size of the gains, what then can he or she control? The downside. Although the investor can never make the price go up from $80 to $120, he or she certainly can make sure to not be holding Deere shares if they go down to $40 or less.

Now, one might oversimplify this issue of control and conclude that investors can control losses but that they have no control over gains. That’s mostly true but, fortunately, not entirely. Even though stockholders cannot push prices higher, once the market has handed them a gain they can make sure that it is not taken away or allowed to turn into a loss. Investors can and should carefully protect their profits. Here’s how.

A well-conceived plan of trailing exits should include effective logic for the exits and the discipline to implement the plan.

A common problem plaguing traders is a lack of discipline. The reluctance to sell stocks at a loss is a well-known problem for investors. Academics commonly refer to this reluctance as the “disposition effect” and many studies show that investors are much more willing to exit a stock at a profit than at a loss.

Overcoming the “disposition effect” requires planning, even before the stock is purchased. The decision process in buying a stock should always include an analysis of where the stock would be sold if it goes down. Once the downside exit point has been determined, then the risk of the purchase can be quantified.

In general, the best policy is to give the initial exit plenty of room (more risk) but balance the increased risk by buying a smaller number of shares (less risk). Using a wider initial exit point will tend to improve the percentage of winning trades at the cost of enduring larger losses.

Research shows that cutting losses too closely can hurt overall performance much more than the effect of accepting slightly larger losses in order to increase the winning percentage.

If the exit is planned in advance, it will be much easier to implement and investors will not feel like they made a hasty decision under the pressure of a falling market. Also, having a plan to buy the stock back if it changes direction to resume an uptrend is helpful—and makes the decision to exit on weakness much easier.

Nothing is wrong with selling a stock to protect capital and then buying back the same stock if the price starts increasing again. The knowledge that the exit may only be a temporary protective action can make the decision to sell more comfortable and improve an investor’s exit discipline.

If a stock runs away to the upside after an exit, the fault is in not being prepared to buy it back, and it is a mistake to fault the exit in hindsight. The decision to sell to protect capital when a stock is falling is always correct, regardless of the price action that follows.

Most trailing exits are simple calculations, using previous low points that trail beneath the current price level. Here are a few examples of popular trailing exits:

1. A trailing dollar amount per share.

2. A trailing percentage of the share price.

3. A trailing moving average of the previous prices.

4. A trailing lowest low of the previous X number of days.

5. A trailing support level based on chart analysis.

The critical flaw in these and many other exit strategies is that they fail to adjust to changes in the volatility of the underlying stock. All traders know that stocks go up and down and that much of this price action is absolutely meaningless. Market technicians often refer to these random price movements as “noise.” If investors set their trailing exits too close, then they are likely to get kicked out of a position for no valid reason. Selling too soon and then seeing the stock resume its uptrend is known as a whipsaw, and is one of the main reasons that a prudent policy of trailing exits is abandoned.

Investors hate to be whipsawed and would rather subject their capital to severe loss than to experience an occasional missed opportunity. However, missing a substantial up move after an exit is not the fault of the exit. The exit has the purpose of protecting against a significant loss, and the exit should not be faulted for doing its job.

If a substantial move up happens to follow an exit, then any loss of opportunity is the result of failing to implement a re-entry plan.

However, investors do not want to exit unnecessarily, even if they have a logical re-entry plan in place. To avoid unnecessary exits and the dreaded whipsaw, they need to have trailing exits that adjust to changes in the volatility of the underlying stock.

If the back-and-forth randomness in a stock is $2 and investors trail an exit at $1 below the price, then they will surely exit simply because the exit is inside the current level of “noise.” Instead of protecting capital, they will be wasting it by exiting on random price action rather than exiting to avoid significant weakness and the beginning of a downtrend that is likely to continue.

A trailing exit is most effective when it adapts to changes in volatility and moves closer or further away to remain just beyond the reach of randomness.

Randomness can best be measured by calculating a simple formula of average true range (ATR), or investors could use a more complicated formula measuring standard deviations. I have found that keeping things simple usually produces the best results, so I recommend the average true range (see Figure 2). ATR is the largest of:

1. Today’s high, minus today’s low.

2. Today’s high, minus yesterday’s close.

3. Today’s low, minus yesterday’s close.

A LITTLE BACKGROUND

Average true range was first introduced by J. Welles Wilder Jr. in his 1978 book New Concepts in Technical Trading Systems, and this useful measurement has been enthusiastically embraced by market technicians. ATR is widely used in a variety of trading applications and has proven to be particularly helpful as a measurement of volatility applied to the task of measuring randomness. ATR is a favorite tool for continuously adjusting trailing exits to avoid the current level of randomness.

In 2008 and throughout the modern era of stock market investing, increasing levels of volatility have created a nightmare situation for investors concerned about risk. Buy-and-hold investors have suffered the most, but more prudent investors using trailing exits have been equally frustrated.

In the recent crashing market, any prudent exit strategy has been rewarded, and in this environment even setting simple trailing exits that do not adjust for volatility would have avoided many catastrophic losses.

But exits that do not adjust for randomness will very likely prove to be a costly mistake in the volatile rising market that is most likely to follow the present decline. High volatility appears to be here to stay and nonadaptive exits will surely result in whipsaw after whipsaw as the market recovers in the future.

However, if traders set their trailing exits in units of ATR, they can participate in any market recovery without the fear of getting unnecessarily stopped out by exits that are much too close. If the average daily volatility is 20 percent or more (as it is now in a surprising number of stocks), it would not make sense to use a trailing exit of only 10 percent (see Figure 3).

The best policy in these volatile conditions is to move the exits outside the randomness by at least two or three ATRs and trade a much smaller position to balance the increased risk of the wider exits. When the market settles down and the volatility contracts, then an exit expressed in units of ATR will move closer and reduce the level of risk. Once the risk is reduced, then position sizes can be expanded to a normal level without the fear of abnormal losses (see Figure 4).

PUTTING IT ALL TOGETHER

• Control what can be controlled. Investors cannot force prices to go up, but they can avoid riding prices down.

• Traders can and should control risk by implementing a strategy of trailing exits that will avoid substantial and catastrophic losses. Buy and hold as we know it is dead. It was killed by extreme volatility and unacceptable levels of risk.

• Any trailing exit strategy must adapt to changes in volatility to avoid needless whipsaws. Average true range is a valuable tool to make the exits adaptive.

• If occasional whipsaws do occur, traders must have a strategy to re-enter the market to avoid missing substantial profit opportunities.

• The current highly volatile market presents opportunity, but risk must always be limited. Use trailing exits based on ATR and keep positions small if the exits are wide. If volatility decreases, then position sizes can easily be increased as exits move closer.

• Before investors purchase stocks, they must have a plan to exit and to re-enter if required.

• Traders have to muster the confidence and discipline to follow their plans.

Investors can take control of their investments for higher profitability, lower risk and some badly needed peace of mind.

Chuck LeBeau is the director of quantitative analytics at SmartStops.net. He has been investing for more than 40 years and is the co-author of Computer Analysis of the Futures Markets. He was a brokerage firm executive for more than 20 years and has managed both a hedge fund and a commodity fund. He has lectured to thousands of investors throughout the world and is best known as an authority on technical indicators, particularly as applied to exit strategies.

Originally published in the February 2009 issue of Stocks, Futures, and Options Magazine.