Online brokers offer various types of orders designed to protect investors from significant losses. The most commonly used order is a stop loss, but active traders should also consider the trailing stop. When these tools are combined, they become even more powerful. 

Stop Loss Versus Trailing Stop

One of the most commonly used methods for limiting losses from a declining stock is to place a stop-loss order. Using this order, the trader will fix the value based on the maximum loss he or she is willing to absorb. Should the share price drop below this value, the stop loss turns into a market order and will be triggered. Once the price falls below the stop level, the position will be closed at the current market price, which prevents any further losses.

Whereas a regular stop loss has a fixed value and can be manually readjusted, the trailing stop automatically shadows the price movement, following the stock's rising price action. Over a period of time, the trailing stop will self-adjust, moving from minimizing losses to protecting profits as the price reaches new highs.

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Trailing-Stop/Stop-Loss Combo For Winning Trades

The trailing stop offers a clear advantage in that it is more flexible than a fixed stop loss. It allows the trader to continue protecting capital if the price drops, but as soon as the price increases, the trailing feature kicks in, allowing for an eventual protection of profit while still reducing the risk to capital.

To better understand a trailing stop, let's consider an example. If you have a $10 stock, you could set the trailing value as a fixed percentage of 5% or a fixed spread of, say, 20 cents. Either way, the trailing stop will follow the day's high by the predefined amount. The important thing to remember is that if the last price drops below the trailing-stop value, the stop loss will be triggered. So, setting a stop too close may cause you to get stopped out more quickly than you hoped.

One of the greatest features of a trailing stop is that it allows you to specify the amount you are willing to lose without limiting the amount of profit you will take. In addition, trailing stops can be used with stocks, options and futures exchanges that support a traditional stop-loss order.

Workings of a Trailing Stop

Consider a stock with a:

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.

During a temporary price dip, it's important that you don't don't reset your trailing stop. If you do, your effective stop loss may end up lower than what you had bargained for. 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.

Take another look at our example above. When the last price hits $10.80, a trader can tighten the trailing stop from 20 cents to 11 cents. This allows for some flexibility in the stock's price movement while ensuring that the stop is triggered before a substantial pullback can occur.

A good active trader always maintains the option to close a position at any time by submitting a sell order at market. Just be sure to cancel any trailing stops you have set, or you could find yourself in a short trade. (Trailing stops work equally well on short positions, but you want to make sure you don't get into a short position by accident!)

The Best of Both Worlds

One of the best ways to maximize the benefits of a trailing stop and a traditional stop loss is to combine them. When you do, it is important to note that initially the trailing stop should be deeper than your regular stop loss. It's also important to always calculate your maximum risk tolerance and then set the main stop loss accordingly.

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 the stock price increases, the trailing stop will surpass the fixed stop loss, making it redundant or obsolete. Any further price increases will mean further minimizing potential losses with each upward price tick.

In other words, initially, the stock was given some flexibility with the staggered values, so it could establish a level of support. By doing this, you can trail a stock's price movements without getting stopped out early in the game, and allow for some price fluctuation as the stock finds support and momentum. Be sure to cancel your original stop loss when the trailing stop surpasses it.

The added protection here is that the trailing stop will only move up. During market hours, the trailing feature will consistently recalculate the stop's trigger point. Basically, if the price doesn't change, then neither will the value of the stop.

Using the Trailing-Stop/Stop-Loss Combo on Active Trades

Now that we've gone over the basic strategy, let's look at a more in-depth example and discuss how an active trader might make use of this technique. 

It is a little trickier to use a trailing stop on active trades because of price fluctuations and the volatility of certain stocks, especially during the first hour of the day. Of course, these fast-moving stocks are the ones that will generate the most money in the shortest time period and are usually the ones active traders love to play.

[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%.

The stock recovered from this dip and continued higher with a new re-entry point, but it is important to set your goals and targets for active trading and stick with them. Most traders would agree that this was a good play!

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 means studying a stock for a day or two before actively trading it.

Next, you need to time your trade. More specifically, look at an analog clock and note the angle of the long arm when it is pointing between 1 p.m. and 2 p.m. – you want to use this 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, as shown in Figure 1.

The advantage of this strategy is that it removes emotion from your trading. It's important to set the value when you are calm, focused and able to make a decision based on the information presented on the charts. Also, don't second-guess yourself. You will be well-served to let the trailing stop work its magic.

Trader Risk

While stop losses and trailing stops are meant to reduce risk, there are some risks traders should consider. For starters, market makers are fully aware of any stop losses you place with your broker and can force a whipsaw in the price, bumping you out of your position and then running the price right back up again. If you like the stock, you can always buy it back.

In the case of a trailing stop, there is also the possibility of setting it too tight during the early stages of the stock garnering its support. If this is the case, the result will be the same. The stop will be triggered by a temporary price pullback, and traders will fret over profit they believe they lost. This is one psychological game that traders should avoid at all costs.

Your best bet is to understand that highly volatile stocks are better managed with an actual stop loss as well as a limit sell order at your target price. Let your online broker earn their commissions – it is much faster than executing a market order yourself.

The Bottom Line

Even though a few risks are involved with using trailing stops, it's important to remember that by combining them with a traditional stop loss, you can minimize losses and protect profits. And there's no way you can go broke locking down profits.