Using Trailing Stop Orders

A derivative of the stop limit order, a trailing stop order is designed with the sole aim of limiting the downside on a position while maximizing potential profit. It works in a similar way to a limit stop, but negates the need for continual management of the limit order.

A trailing stop order is most likely to be used by the position trader, who might have bought a single position, or built up a position over a period of time, and has seen the stock price rise while holding his shares. He’s now in a healthy profit, but is concerned that the trend might suddenly reverse, and that if it did he could rapidly turn from sitting on a profitable position to racking up a sizable loss.

The trader still feels that the stock price has a way to run, so he doesn’t want to sell his shares. On the other hand, because the share price has risen so much, or perhaps because of the economic environment or the broader stock market outlook, the trader is a little nervous about the potential downside. If the upward trend cracks and serious selling appears, then the share price could rapidly move down below his the price that he paid for his position, and his losses mount.

Imagine that you’ve bought shares in a company that you think has great prospects for share price growth over the next few days, or perhaps have a holding that is showing a healthy profit. You survive by making money. So, as well as keeping your losses to a minimum, you also concentrate on ensuring your profitable trades make as much as possible. You have a number of options open to you with regard to this profitable position:

  • You could sit tight, and hope that the stock continues to rise. If it does, that’s great, but you are then left with the question ‘when to sell?’ If the share price reverses, you start seeing your profit erode. Again, when do you sell? Perhaps the position even turns negative, and what was once a profitable trade turns to a loss making position.
  • You could sell the shares, and bank the profit to date. But how would you feel if the stock moved up another 10% after the fact?
  • Perhaps you might decide to sell some of your shares, banking some profit and protecting your cash position that way. But again, how would you feel if the stock moved better again? You’ve lost out on a greater profit. And what if the share price does turn south? You may have sold some of your shares, but why didn’t you sell the whole position? You could end up kicking yourself.
  • A further option is to place a sell stop limit. Perhaps you’ve looked at the charts and the trading pattern of the stock, and believe that a fall of 2% from any short term high leads to further falls. So you place a sell stop limit order 2% below the current market price. This protects the profit that you’ve made on the purchase. But to keep this limit up to date, you need to continually manage the stop limit.

To achieve the very best deal, this order management needs to be done on a minute by minute basis. That’s a lot of time to spend monitoring and updating a single limit order, and means that all that time and concentration is deflected from seeking out and executing other profitable trades.

This is where the trailing stop loss order comes into its own.

The best way to see how effective such an order can be is to look at the trailing stop order example below.

You use both technical analysis (chart patterns and previous price performance) and fundamental analysis (digging down into the balance sheet, profit and loss accounts, etc) and decide that ABC shares are a buy at $43. Having conducted your research and come to this conclusion, you buy 1,000 shares at $43, with the intention of holding for a few weeks.

After a just a few days, the shares have risen to $48. While you’re happy that your decision is right, you get a little nervous because of the rapidity of the rise. But you still have that feeling the shares could continue to go up, and don’t want to miss the potential profit that further share price firmness would give.

In order to protect the majority of your profit, whilst benefiting from further share price increases, you could place a trailing stop order to sell 1,000 shares 2% below market. What this means is that if the share price falls 2% from the market price, then a sell order would be executed for you, allowing taking the profit at that time and leaving you with no risk on the downside.

But it gets better. Because the order is a trailing stop, then the 2% limit below the market price follows the highest price in the market throughout the time the trailing stop is live. When you placed the trailing stop, with the share price at $48, a fall to $47.04 would have seen the sell order executed. If the stock continues to rise, so does the sell limit price. For example, should the share price hit $50 then the trailing stop limit is automatically increased to $49. If the stock falls to $49, from a high of $50, then your shares will be sold at $49.

But if the stock only falls to $49.20, you trailing stop order won’t be executed. If the shares then move up to, say $51, the trailing stop is then adjusted to $49.98. And so it goes on.

The benefits of using trailing stop orders are plentiful.

You don’t have to continually monitor the stock. You benefit from further increases in the stock price. And you protect yourself from a rapid reversal and a sharp downward movement. Three great reasons to make sure you add trailing stops to your trading armory.

No comments yet... Be the first to leave a reply!

Leave a Reply