Online brokers offer various types of orders that are designed to protect investors from significant losses. The most commonly used order is a stop loss, but there is another type of order that ought to be considered: the trailing stop. Find out why trailing stops are fast becoming a solid tool for active traders.
The Stop Loss
One of the most commonly used methods for limiting the amount of loss from a declining stock is to place a stop-loss order with your broker. Using this order, the trader will fix the value based on the maximum loss he or she is willing to absorb. Should the last 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.
The Trailing Stop
A trailing stop and a regular stop loss appear similar as they equally provide for the protection of your capital should a stock's price begin to move against you, but that is where their similarities end.
The trailing stop offers a clear advantage in that it is more flexible in nature than a fixed stop loss. It is an attractive alternative because it allows the trader to continue protecting his 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 that the trailing value is either a fixed percentage of 5% or a fixed spread of 35 cents. Either way, the trailing stop will follow the day's high by the predefined amount. The important part is that once set, it cannot fall back and if the last price drops lower than the trailing-stop value, the stop loss will be triggered.
Similarities and Differences
Any time the word "stop" appears in an order, you know the trader is asking the broker to minimize risk to his or her trading account.
Whereas a regular stop loss has a fixed value and could be manually readjusted by the trader, the trailing stop automatically shadows the price movement, following the stock's rising price action. This type of trailing order freely allows the trader to watch over more than one open position.
Over a period of time, the trailing stop will self-adjust, moving from minimizing losses to protecting profits as the price reaches new highs.
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 are available for stocks, options and futures exchanges that currently support a traditional stop-loss order.
The Workings of a Trailing Stop
Purchase Price = $10
If the market price climbs to $10.97, your trailing stop value will also 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 reset your trailing stop. If you do, your effective stop loss may end up lower than what you had bargained for. In 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 sample stock above. When the last price hits $10.80, an alert trader will tighten his 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. And yes, trailing stops work equally well on short positions.
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. Yes, you can use both, but it is important to note that initially the trailing stop should be deeper than your regular stop loss. It's also important for the trader to always calculate maximum risk tolerance for his or her portfolio and then set the main stop loss accordingly.
An example of this concept is to have a stop loss set at 2% and the trailing stop at 2.5%. As the 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. Initially, the stock was given some flexibility with the staggered values, so it could establish a level of support. By doing this, you are able to trail a stock's price movements without getting stopped early in the game and allowing 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.