Online brokers are constantly on the lookout for ways to limit investor losses. One of the most common downside protection mechanisms is an exit strategy known as a stop loss order, where if a share price dips to a certain set level, the position will be automatically sold at the current market price, to stem further losses.
But traders may enhance the efficacy of a stop loss by pairing it with a trailing stop, which is a trade order where the stop-loss price isn't fixed at a single, absolute dollar amount, but is rather set at a certain percentage or dollar amount below the market price. When the price increases, it drags the trailing stop along with it. Then when the price finally stops rising, the new stop-loss price remains at the level it was dragged to, thus automatically protecting an investor's downside, while locking in profits as the price reaches new highs.
- With a stop loss order, if a share price dips to a certain set level, the position will be automatically sold at the current market price, to stem further losses.
- But traders may enhance the efficacy of a stop loss by pairing it with a trailing stop, a trade order where the stop-loss price isn't fixed at a single, absolute dollar amount, but is rather set at a certain percentage or a dollar amount below the market price.
Trailing-Stop/Stop-Loss Combo For Winning Trades
Workings of a Trailing Stop
To better understand how trailing stops work, consider a stock with the following data:
Purchase price = $10
Last price at time of setting trailing stop = $10.05
Trailing amount = 20 cents
Immediate effective stop-loss value = $9.85
If the market price climbs to $10.97, your trailing-stop value will rise to $10.77. If the last price now drops to $10.90, your stop value will remain intact at $10.77. If the price continues to drop, this time to $10.76, it will penetrate your stop level, immediately triggering a market order. Your order would be submitted based on a last price of $10.76. Assuming that the bid price was $10.75 at the time, the position would be closed at this point and price. The net gain would be 75 cents per share, less commissions, of course.
During momentary price dips, it's crucial to resist the impulse to reset your trailing stop, or else your effective stop loss may end up lower than expected. By the same token, reining in a trailing stop loss is advisable when you see momentum peaking in the charts -- especially when the stock is hitting a new high.
Revisiting the aforementioned example: when the last price hits $10.80, a trader can tighten the trailing stop from 20 cents to 11 cents, allowing for some flexibility in the stock's price movement, while ensuring that the stop is triggered before a substantial pullback can occur. Shrewd traders maintain the option of closing a position at any time by submitting a sell order at market.
The Best of Both Worlds
When combining traditional stop losses with trailing stops, it's important to calculate your maximum risk tolerance. For example, you could set a stop loss set at 2% below the current stock price and the trailing stop at 2.5% below the current stock price. As share price increases, the trailing stop will surpass the fixed stop loss, rendering it redundant or obsolete. Any further price increases will mean further minimizing potential losses with each upward price tick. The added protection is that the trailing stop will only move up, where during market hours, the trailing feature will consistently recalculate the stop's trigger point.
Using the Trailing-Stop/Stop-Loss Combo on Active Trades
Trailing stops are more difficult to employ with active trades, due to price fluctuations and the volatility of certain stocks -- especially during the first hour of the trading day. Then again, such fast-moving stocks typically attract traders, because of their potential to generate substantial amounts of money in a short time. Consider the following stock example:
[Trailing stops are just one way to control the risk-reward ratio when trading. Investopedia's Technical Analysis course will show you how to use these strategies and many others to control risk and maximize returns.]
Purchase price = $90.13
Number of shares = 600
Stop loss = $89.70
First trailing stop = 49 cents
Second trailing stop = 40 cents
Third trailing stop = 25 cents
Figure 1: A trailing stop-loss order
In Figure 1, we see a stock in a steady uptrend, as determined by strong lines in the moving averages. Keep in mind that all stocks seem to experience resistance at a price ending in ".00m" and also at ".50," although not as strongly. It's as if traders are reluctant to take it to the next dollar level.
Our sample stock is Stock Z, which was purchased at $90.13 with a stop loss at $89.70 and initial trailing stop of 49 cents. When the last price reached $90.21, the stop loss was canceled, as the trailing stop took over. As the last price reached $90.54, the trailing stop was tightened to 40 cents, with the intent of securing a breakeven trade in a worst-case scenario.
As the price pushed steadily toward $92, it was time to tighten the stop. When the last price reached $91.97, the trailing stop was tightened to 25 cents from 40 cents. The price dipped to $91.48 on small profit-taking, and all shares were sold at an average price of $91.70. The net profit after commissions was $942, or 1.74%.
For this strategy to work on active trades, you must set a trailing-stop value that will accommodate normal price fluctuations for the particular stock and catch only the true pullback in price. This can be achieved by thoroughly studying a stock for several days before actively trading it. Next, you must be able to time your trade by looking at an analog clock and noting the angle of the long arm when it is pointing between 1 p.m. and 2 p.m., which you'll want to use as your guide. Now, when your favorite moving average is holding steady at this angle, stay with your initial trailing stop loss. As the moving average changes direction, dropping below 2 p.m., it's time to tighten your trailing stop spread (see Figure 1). The advantage of this strategy is that it eliminates the emotional component from trading, letting you rationally make measured decisions based on statistical information.
Traders face certain risks in using stop losses. For starters, market makers are keenly aware of any stop losses you place with your broker and can force a whipsaw in the price, thereby bumping you out of your position, then running the price right back up again. And in the case of a trailing stop, there looms the possibility of setting it too tight during the early stages of the stock garnering its support. In this case, the result will be the same, where the stop will be triggered by a temporary price pullback, leaving traders to fret over perceived lost. This can be a tough psychological pill to swallow.
The Bottom Line
Although there are significant risks involved with using trailing stops, combining them with traditional stop losses can go a long way towards minimizing losses and protecting profits.