When you have a stock that you fear might decline in value and cause you to incur huge losses, usually what you’d do is place a stop-loss order. A stop-loss order allows you to set a value below the current market price that if the stock drops below it, it triggers the stop-loss order. When it’s triggered, it becomes a market order thus closing your position at that market price. This helps limit your losses.
But what if you want the set value to be automatic and to change up and down as the stock prices go up and down? You’d want to open trading again once the prices go up and you make a profit. You also would want to protect your profits, so that your stop-loss mechanism should be flexible and “shadows” the prices so that if the value of the stop drops again, it automatically triggers to prevent you from losing those profits. In that case what you want is the trailing stop-loss method. Here are some powerful techniques that work.
Trailing Stop in Action
Unlike the stop-loss method, the trailing stop isn’t limited to a fixed value. You can use a percentage to track the stock’s rising price. That way the trailing stop will adjust itself as the market goes up using that percentage you set. With time it will turn from a loss-stopping method into a profit protecting tool. This flexibility gives you a clear advantage. Because while it allows you to set the amount you’re willing to lose, it doesn’t put any limitation on your profits. Furthermore, trailing stops are not limited to stocks. They can be used with options and futures exchanges as well.
Using the Trailing Stop
Let’s say you have a stock you bought at $15. You set a trailing stop of 25 cents on it. At that time the stock’s price is $15.07 which means that if the stock drops below $14.82 the trailing stop will be triggered. Now the stock starts to climb and reaches $15.82. Your trailing stop automatically moves up to $15.57. If the stock’s price drops to $15.70 the trailing stop won’t change and stays at $15.57. But if the price keeps falling and reaches $15.56 that will trigger the trailing stop into becoming a market order. Your order’s price will be $15.56. If the bid price was $15.55 that would close your position at this price and you make a profit of 55 cents before commissions.
Make it Work
Now you might be tempted during a slump in prices to reset your trailing stop loss. That’s a rookie mistake and could render the whole technique ineffective since you would get a stop loss much lower than you would want.
However, when the situation reverses and your stock starts to climb and you expect it to peak, you should limit your trailing stop. This is especially true when the stock is hitting highs it hasn’t reached before.
As you start putting these techniques into practice, you’d come to realize that setting limits for profits or losses is not an easy process. There’s no golden rule for this, and only experience and a gut feeling are your only guides here. It all has to do with the type of trader you are. A conservative trader would lean toward cautious margins while a risk-taking trader might follow a different approach.
Trailing stop-loss is a better approach than fixed stop-loss methods since it not only caps your losses in case the price dips, but it also protects your profits when the stock is gaining. Learning to use this advanced technique will help you become a better trader and increase your margin profits.