The trailing stop percent is an excellent method to protect against large losses while capturing much of a move in a trend. Volatility or range of movement over time in the price of a security can be an advantage as well as a detriment to investors. The purpose of the trailing stop percent is to accommodate a security’s volatility. Properly placed, a trailing stop percentage can help investors capture a significant portion of a trend move. On the other hand, an investor will see their position closed prematurely if a trailing stop percent is misaligned with the volatility of the share price.
A trailing stop percent follows price movements by a set percentage, but only in the direction of the trend. If the price reverses direction, the stop remains at its previous level. Should the share price fall and hit the price calculated by the trailing stop percentage, the position would close. Each time the share price reaches a new high, the trigger price adjusts according to the trailing stop percent following the price higher. If the stock’s price begins to fall and reaches your trailing stop, an order is sent to the appropriate exchange as either a market order or limit order. If the order is a market order, your stock sells for the best available price. If your broker allows you to enter your trailing stop percentage as a stop limit order, then your order is sent as a limit order and will execute if the price trades at the limit price. Be cautioned as a limit order may not execute. There must be a corresponding buy to match your sell order. To be confident you execute your trailing stop percent, I suggest you do not restrict your order by placing it with a limit.
For example, assume you bought Exxon (XOM) on the last day
Successful investors follow several simple steps when they set their trailing stop percentage:
The volatility of a security is at the heart of setting the trailing stop percent. There are two methods to determine the volatility of a security used by investors. One method is based on an indicator know as Average True Range (ATR).
Average True Range
Average True Range (ATR) determines a security’s volatility, or the tendency of a security to move up and down, over a given period. Calculating the ATR starts with finding the true range for your security. The true range is the greatest of the following:
By calculating a moving average of the true ranges over a set number of previous periods, usually 14, you can calculate the ATR. The choice of periods can by minutes, hours, days, weeks, or months, depending on your time frame. The number returned by the average true range calculation is a measure of how much a security has moved either up or down over the defined period. Higher values indicate the prices are changing more during the period. While lower values, indicate the prices are changing less over the period. In addition, the low priced securities will have lower ATRs than high priced securities.
To set your trailing stop percentage, divide the ATR by the current share price giving you a percentage. You may use this percentage as your stop loss. Other investors will double the ATR before calculating the percentage stop loss. They are more risk tolerant and willing to take more down side loss in return for not experiencing a premature close out on a dip in the price. The multiple you use is a way to address your tolerance for risk; the higher your tolerance for risk, the larger the multiplier.
To learn more on how to use the Average True Range (ATD) to calculate your trailing stop based on volatility see the article titled Average True Range, the Volatility Indicator.
Stock charting services, such as stockcharts.com may include an ATR indicator, simplifying the ATR calculation.
Average Daily Volatility
Another way to set the trailing stop percentage is using the daily average volatility of the stock. To determine the average volatility compute the average daily high-low price range for the prior period such as the last month, and then divide the result by the current low price. This will give you the percentage stop based on volatility. Again let's use Exxon Mobil, this time for the month of July 2005.
The difference column is the
intraday high minus the low. The average of the differences for the month
is 1.15. Based on testing by Thomas Bulkowski, author of
Encyclopedia of Chart Patterns (Wiley Trading), 2 seems to be the best multiplier to keep from
being stopped out to early. Multiply the average difference of 1.15 by 2 to get
the volatility, or 2.30. Converting this number to a percent gives us
2.3/58.75=3.9%, using the low from the last day of the month, which was
58.75. This places your stop initially at 56.45. Keep in mind that this stop
will rise with each new high achieved by Exxon just as before. On
The trailing stop loss percent is a valuable tool for any successful investor or trader. By accounting for a security’s volatility, the stop loss percentage provides an investor with a way to capture much of a trend’s move and reduces the threat of a premature sale.