A Trailing Stop Loss
Allows profits to run and losses to be controlled!
A trailing stop loss
, or rolling stop loss, is one that automatically generates a sell order at a price set by the purchaser.
This price, called the trigger point, is set at a certain percentage below the highest price realized by the stock.
The highest price reached might be the price you paid for the stock! If it goes down from there, you need to decide at what point you want to exit the trade.
As well as the trigger point, my broker requires a limit price. The limit price represents how far below the trigger point, that is how much slippage I am prepared to accept in order to effect a sale.
If the price of the stock is falling rapidly, the price may fall through the limit price and as a result, no sale will be achieved.
To overcome this problem, some brokers offer a guaranteed stop loss. That is, a guaranteed sale at the trigger point. But it comes at an additional cost.
Setting a Trailing Flat Percentage Stop Loss
The difference between your buying price and the lower price at which you are prepared to exit, expressed as a percentage of the buying price, may provide an indication of the trailing flat percentage stop loss you are comfortable with.
This could be in the range of 10% to 15% of your purchase price depending on how risk averse you are.
If the stock rises in price, this percentage represents how much you are prepared to drop from the highest price reached before you sell it to lock in profits.
Percentage of Capital Stop Loss
Most short term traders use 2% of total capital to determine their stop loss. In so doing they are prepared to risk at most 2% of their trading capital on any one trade.
So if they trade with a nest egg of $50,000 and put $5,000 on one trade, 2% of $50,000 is $1,000. So in this case they are prepared to lose a maximum of $1,000/$5,000 which converts to a 20% loss on the cost of any one trade.
Volatility Based Stop Losses
There are a variety of other ways of setting a stop loss. One of these which is the volatility based stop loss bases the setting of the stop loss on the volatility of the stock price.
The volatility is measured by how much the price rises and falls in a particular time period, which could be a day, or a week, depending on whether you are a trader or an investor.
Trading packages can provide a volatility value for particular stocks, or you can get an estimation by looking at a price chart.
The greater the volatility of the stock price, the wider you may need to set the stop loss so that you reduce the possibility that you trigger the stop loss and find that the stock price gets new life!
Setting the Stop Loss Trigger Point
You need to reset the stop loss trigger point as the stock price moves. How frequently this needs to be done depends on what type of trader you are.
This could vary from daily to weekly to monthly to find the highest price hit and using this price to recalculate the new stop loss trigger point.
While the trailing stop loss strategy is commonly used by day traders who are operating on short time frames of a few days or less, it can also be useful for value investors whose time horizon is measured in years.
It is particularly useful for those (most?) of us who have difficulty in selling when share prices drop. And it is also useful if you are on vacation!
Having a trailing stop loss in place overcomes the barrier to selling when emotions can hold sway because the sale occurs automatically.
However, as a value investor, setting stop losses has always been somewhat problematic for me. This is because I attempt to have a margin of safety when buying a stock. Selling the stock below the margin of safety level would seem to make good sense.
But a lower price might suggest that the stock is better value.
So it becomes a question as to whether the story about the stock is still valid or whether circumstances have changed sufficiently to suggest exiting the stock.
I consider each stock individually, and if a particular stock merits a greater safety check then I consider a trailing stop loss order.
Return from Trailing Stop Loss to Safe Investing