Tuesday, January 22, 2013

What is a Trailing Stop?

A trailing stop is an order entered with a stop parameter that creates a trailing or moving activation price.

What does that mean?   

Example # 1:  Let’s say you bought a company’s stock for $10 and that stock is currently trading at $15/share.  If you had entered e.g. a 3% trailing stop sell order, and the stock were to fall in value by 3% or more from its new high at $15/share (about $0.50), the trailing stop order will help prevent you from losing too much of your posted gain.

In a bull market (when stocks are going up)... you effectively will not lose money using this methodology, although it is possible that you may have been able to achieve a greater gain without the trailing stop order executing (commonly aka greed)!  

When the bears pounce (when stocks decline in value)... you limit your losses - if any - within a set percentage or dollar range that you have pre-determined, and are comfortable with!

Example # 2:  As the bid price for the stock moves up, the activation price (for the sell order) trails the new, higher value.  Using my “$10 buy / $15 current” stock price example above, if the stock were to move from $15/share to $20/share over a period, the trailing stop sell order will trail the increased price over that same period, e.g. becoming 3% of $20 (or about $0.60/share).  This means that if the $20/share stock were to lose about $0.60/share in value – having fallen from it’s bid price of $20/share – the trailing stop order will be activated, becoming a market order.

Example # 3:  But stocks also go down in value.  So, conversely, if you had bought the stock at $10/share and this stock is currently trading at $8/share, you could enter e.g. the same 3% trailing stop sell order to mitigate your risk of losing more of your investment.  If the bid price for the $8/share stock then declined by about $0.25, it would trigger the sell and your position will be closed at around $7.75/share, limiting potential further financial loss.

Why should we use a trailing stop sell order?

Firstly, to help manage and control your investor emotion!  Secondly, for long positions (where you intend to own the shares for a while), this technology – provided by your online brokerage account (or broker) – will help maximize and protect your profit in rising markets, and limit your losses in falling markets… and everyone would like to achieve that, right?

Above I’m discussing Trailing Stop Sell Orders, but the same functionality can also be used for buy orders.  When selling short stock positions (when an investor expects the stock price to go down) a Trailing Stop Buy Order can help protect profit in falling markets and limit loss in a rising market.

An illustration, courtesy TD Ameritrade:

Be sure to explore and become familiar with these (and other) technology tools that are often available at no cost to investors… tools that will assist you in managing your investor emotion, and help you in your quest to achieve a maximum return on your investments! 

Best of success with your investment decisions!