When Do I Use a Trailing Stop?The trailing stop order tool allows seasoned traders and beginning investors to overcome the most difficult aspect of investing: knowing when to sell. Taking profits and cutting losses is frequently the most emotional and potentially dangerous situation that investors face, but a trailing stop can eliminate emotion from the equation, letting profits run and managing risk. Risk management is at the heart of every good trading strategy, and this tool can provide that discipline to a beginners portfolio.
Now, before I dive a little deeper into using trailing stops I will say this…I rarely use them with penny stocks. Why? Quite simply market makers have the ability to use your stop loss order and other traders stop loss orders to provide sell orders that are large enough for bigger investors or institutions to get in on. This is especially true for the volatile penny stocks many of us like to trade. How many stocks have you witnessed or traded that fell sharply at a consolidation point in price taking out most of the stop orders traders set? Then, within minutes the stock surges back up through the choke point and hits new highs! I see this virtually every morning. So, that’s why I rarely use trailing stops with penny stocks or small caps. With less volatile mid-large cap stocks it’s a much safer practice.
So…now that I’ve covered that, using a trailing stop IS an easy and free way to manage risk in addition to letting your profits run.
Trailing Stop = Risk Management
As I mentioned earlier one of the most difficult aspects of investing, for both swing traders and long-term investors, is knowing when to take profits or cut losses. Taking profits too soon might leave a lot of potential gain on the table; taking a 10 percent gain in a stock that continues on to a 50 percent gain, missing out on 40 percent, feels almost as bad as losing 20 percent. On the other hand, cutting losses too late is costly and dangerous, as it suggests there is no limit to the risk involved in any one trade. Managing individual risk is the foundation for any strong investing strategy, and trailing stops can simplify risk management strategies for seasoned and beginning investors alike.
This technique involves a free stop-loss order set at a certain percentage below the price at which the position was bought. For a losing trade, the stop-loss triggers a sell order when the price passes the set percentage, minimizing risk at the discretion of the investor. For a winning trade, the trailing stop follows the fluctuations of the market price upwards, triggering a sale only after the price of a stock has reached a peak and fallen a certain amount. Effectively, the order takes the emotion out of the decision to sell, allowing traders and investors to take a healthy step back from their trades after buying.
What is essential to consider in setting a trailing stop order is how much room to give the position. For stocks with significant volatility, setting a stop at a tight percentage could choke a trade or cause the sell order to trigger before the stock price has had a chance to consolidate and move upwards. It often takes practice for investors to learn what levels of risk they are comfortable with taking on in exchange for giving trades room to move. Some trailing stops are anchored to a naturally trailing metric, like a moving average, which is useful in short-term trading strategies. Most commonly in this arena, traders anchor their stops to the Average True Range, which accounts for volatility and provides a healthy gap between the stock price and the sale trigger.
For individual investors, the stop order is an essential tool when positions cannot be constantly monitored. They also provide the function of eliminating emotion from the trading equation. This element contributes discipline to a stock trading strategy, a fundamental necessity for risk management.