Trailing Stops can Limit Risk and Lock In Profits
Trailing stops are a great trading strategy that uses stop loss orders. Simply put, as the price of the stock goes up, your trailing stop will also go up. The trailing stop prices are set at a certain percentage (%) below the current price.
As the price of the stock goes up, the trailing stop will also go up. The stop follows, or trails, the stock price, giving us the name “trailing stops”.
Only Raise Your Trailing Stop – Never Lower It!
The advantage of using trailing stops is that you only raise your trailing stop price. You never lower your trailing stop!
Why do you only raise trailing stops? You want to only raise your trailing stops to reduce risk and lock in profits.
Examples of Using Trailing Stops
Here are examples of trailing stops in action.
You buy XYZ stock at 10.00. In this example we will set our trailing stop price at 10% below the current price. Our initial trailing stop will be 9.00. How did I get 9.00? Take 10% of 10.00 to get 1.00. We’ll set the initial trailing stop at 1.00 less than the current price of 10.00. Subtract 1.00 from 10.00 to get 9.00. If the stock price hits 9.00, our trailing stop will sell our position.
Scenario: Stock Moderately Decreases in Price – XYZ stock declines in price! If XYZ declines in price to 9.50, you will not alter your trailing stop – do not lower your trailing stop order price!
Scenario: Stock Sharply Decreases in Price – XYZ is falling fast! First it hit 9.50, then kept dropping and now it is approaching 9.00. When the price of XYZ hits 9.00, our trailing stop will automatically sell the stock. We will have lost 10% of this trade’s value. Keep in mind that this is 10% of only this trade, not 10% of our total portfolio value. We knew we were risking 10% of our money in this trade. This risk is money we were willing to lose. If XYZ keeps falling to 8.00, we’ll be protected thanks to our trailing stop – we will have sold this position (at a loss) at 9.00. Our risk was limited to 10%. If we didn’t have a trailing stop in place, we would currently be down 20% on this trade – 10.00 price falling to 8.00 is 20% decline.
Scenario: Stock Moderately Increases in Price – XYZ stock increases in price! If XYZ stock prices goes up to 11.00, we will alter our trailing stop. The new trailing stop price will be 10% below 11.00. First calculate this price by taking 11.00 * 10% (10% is the same as multiplying by .10). So we have: 11.00 * .10 = 1.10. Second we will calculate the current price of 11.00 minus 1.10. We’ll set our trailing stop price at 11.00 – 1.10 = 9.90. If XYZ stock hits 11.00, our trailing stop will be 9.90.
Scenario: Stock Sharply Increases in Price – XYZ shoots up to 15.00 per share. We’ll have to calculate a new trailing stop price, again 10% lower than the current price. First calculation: 15.00 * 10% (or .10) = 1.50. Second calculation: 15.00 – 1.50 = 13.50. Our new trailing stop price is 13.50. The return rate from 10.00 to 13.50 is 35%! We’ve just locked in 35% in gains. If XYZ hits 13.50, our trailing stop loss order will automatically sell XYZ at 13.50. If XYZ falls to 9.00 per share, we won’t care. We’ve locked in profits and our trailing stop sold our positions for us.
Trailing Stops Reduce Risk
Trailing stops reduce risk by setting an absolute minimum price and monetary value you are willing to risk and possibly lose. For simplicity I will use a trailing stop price of 10% below the current stock price. The trailing stop price you use depends on your trading style, strategy, and amount of risk you are willing to accept. Some people may want to set a trailing stop at 5% below the current price, while others use upwards of 20% below the current price.
Keep in mind that some stocks are volatile and may fluctuate 5% to 10% in price per week. If your trailing stop is set at 5% below the current price, and the stock falls 5% shortly after you buy it, your trailing stop will execute and sell your stock position at a 5% loss. However, if your trailng stop is set at 10% below the current price, the stock price can initially fall 5%, then the stock price may shoot back up. Volatile stocks require careful research and analysis before you determine the trailing stop percentage to use.
Trailing Stops Lock In Profits
Trailing stops lock in profits or reduce losses when the price of the stock goes up. As the stock prices increases, your trailing stop price also increases.
If the stock continues increasing in price – say 20% above the price you purchased at – your trailing stop will lock in 10% in profits. If the stock continues climbing and hits 40% above the price you bought it, your trailing stock will also climb, locking in a 30% gain! When the stock finally declines in price, your trailing stop will sell your position, locking in a gain of 30% profits for you.
Use Trailing Stops!
Everyone should use trailing stops. They benefit you in two ways: reducing risk and locking in profits. Trailing stops are a very important and useful tool available to traders and investors, but many traders do not use them. If you plan on being a successful trader or investor, trailing stops are an easy way to increase your profits and your chances of success.
A stock trading plan is a strict set of rules and actions which formulate your stock trading strategy. A stock trading plan defines when to buy and sell stocks and at what prices. Every trade you make should be governed by your trading plan.