If you are learning to invest, then it is essential to understand how to use the trailing stop order. There is an old rule in the market, often repeated by Jim Cramer on his “Mad Money” program on CNBC: “Bears win, bulls win, pigs get slaughtered.” This means that those who hold on to their stock too long will end up losing money. Too bad they did not know about the trailing stop technique, which is similar to Stop Loss Orders.
So, when should you sell your stock? Stock selling strategies are just as crucial as your stock buy strategy. While there are many reasons to sell your stock, today, we will cover the various trailing stops that can be used to close out your position when the price falls back to a predetermined level.
How many of us have held stocks in our portfolios that performed well, only to have them pull back below our purchase price? If only we had a tool that could manage our downside risk, so we get out earlier with the gains we made. All too often, we delay selling when our stocks start to show a downturn in the hopes that the decline is temporary and the price will recover. Trailing stops can be used as a disciplined approach to managing our stock exit strategy when you have gained in your stock or wish to limit losses.
Being an astute investor who uses this online Trading Markets, you bought MSFT when it broke out on 11/23/1998 at 25. Over the next two months, it rose to more than 32.5 and then fell back to about 30 before rising again. Looking at the chart, you notice that there seems to be supported at 30, especially when you look at the buying volume as the price tested 30 and then moved sharply up to 37.5 by the end of January 1999. Using 30 as your support, you decided to set your new trailing stop price at 29.93. I like to set my stops just below support and with an odd number to help keep the market makers from taking me out on any dip to support. In February and early March, the price of MSFT falls to slightly below 32.5 and then seems to make its next move up from there, building a small base at 32.5. You decide to move your trailing stop-loss price up to just below 32.5, let’s say 31.83, to give it some room below support at 32.5. Setting the stop at 31.83 is fairly arbitrary. You want to balance not being taken out by a brief dip with selling on any meaningful reversal in the price trend. Then MSFT makes a nice move to 42 as its next high before pulling back to about 33, where it consolidates for a month and a half. The next move takes the price up above 42.5 briefly. As a result, you move your trailing stop up to just under the latest support level at 33, selecting 32.83. This move up and then down to form new support levels continues through November 1999. Being a good investor, you move your trailing stop price up 2 more times, first to just under 35.5 and then again to just under 36.5. You have now locked in 16.5 points of profit per share or 66% in a year’s time—a very nice return. Then in December 1999, MSFT makes a dramatic move up to above 50. These sharp moves up often are indications of a final buying spree by investors late to the game seeking to be part of a great investment. Most times, they are late to the game. You observe that MSFT encountered substantial resistance at 42.50 before it broke through in a dramatic fashion. Resistance, once broken through, becomes support. Therefore, you decide to move your trailing stop price up to just below 42.50. Since MSFT made such a sharp move up, likely due to the more naive investors trying to get in late, you decide that you want to keep your stop close to this support level, choosing 42.43. On January 31, 2000, your stop was executed, resulting in 17.43 points per share or a very nice 70% gain in 14 months. While MSFT did go back up to 50 briefly, it then quickly plunged to 30 in May 2000, probably trapping all those investors late to the party with substantial losses.
This example gives you a good idea of how to use trailing stop prices to capture the bulk of an uptrend. It is important to regularly monitor your stock’s chart to assess if you need to adjust your stop. In this example, I used to support and resistance levels, indicating the psychological levels that buyers and sellers tend to use. Technicians also use trend lines, various technical indicators, and moving averages, especially 50 days and 200-day moving averages. All are valid methods. Notice on the chart that the selling volume of MSFT jumped when it penetrated the 200-day moving average in early November 1999. Looks like a lot of people were using this moving average as their trailing stop.
There are three primary ways to set a trailing stop order. The first two reset themselves automatically. The three trailing stop methods are:
- a percentage below the current price;
- a fixed number of points below the current price and;
- a specific stop price based on a technical indicator or support level that you adjust as your stock price rises.
Trailing Stop Percent
The 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 and will be activated should the price fall below the trailing stop percentage. The trigger price is readjusted each time a new high is reached. If the stock’s price begins to fall and reaches your trailing stop, your order will be triggered as a market order, and your stock will be sold for the best available price. If your broker allows you to enter your trailing stop percent as a stop-limit order, then your order will be executed at the limit price if it continues to trade at this price. Using a limit price with your trailing stop order does not guarantee your order will be executed, as there must be a corresponding buy to match your sell order. To be sure you execute your trailing stop percent, I suggest you do not restrict your order by placing it with a limit.
For more on how to use the trailing stop percent, please see the article titled, not surprisingly, Trailing Stop Percent.
Trailing Stop Price
Another way to set your trailing stop is to use a trailing stop price. This method is very similar to the trailing percent method, only you use a set number of points below the high price instead of a percentage. If the price reverses direction, the trailing stop price remains at its previous level and will be activated if the price falls by more than the trailing points. The trigger price is readjusted each time a new high is reached. If the stock’s price begins to fall and reaches your calculated stop price, your order will be triggered as a market order, and your stock will be sold for the best available price. If your broker allows you to enter your trailing points stop as a stop-limit order, then your order will be executed at the limit price if it continues to trade at this price. Using a limit price with your trailing stop order does not guarantee your order will be executed as there must be a corresponding buy to match your sell order. To be sure you execute your trailing points stop, I suggest you do not restrict order by placing it with a limit.
The only difference in Trailing Stop Price vs. Trailing Stop Percent is the trailing percent is proportional, so there will be a slight variance in the absolute stop. Other than that, there is no difference in the use of the two methods of setting your trailing stop. To learn more on how to use the trailing stop price, please see the article titled Trailing Stop Price.
Trailing Stop Indicator
The third way to set a trailing stop is to use a stock price indicator. This technique takes advantage of the market psychology that is embedded in the price and volume of a stock.
Technicians call these levels support and resistance. Support is the level at which stock seems to find more buyers than sellers and, as a result, usually has difficulty going lower. Support levels are where buying overcomes the selling that is causing the price to fall. Resistance is the level where a stock seems to find more sellers than buyers and usually has difficulty going higher. Often these areas are where the stock price has stopped going down and started going up again. The chart of Microsoft (MSFT) use in the example above is used to support and resistance levels to set trailing stop price.
Technicians also use trend lines, various technical indicators, and moving averages, especially 50 days and 200-day moving averages. Notice on the chart that the selling volume of MSFT jumped when it penetrated the 200-day moving average in early November 1999. Looks like a lot of people were using this moving average as their trailing stop.
So, which trailing stop should you use? I am unaware of any study that statistically proves one is better than the other. Successful investors and traders use each method. I like to use both the trailing stop percent and the trailing stop indicator. These two methods have some basis in the behavioural psychology of the market. I examine the stop each method identifies and then choose the one that seems to fit the current situation the best. I also use what I know about the overall market trends and cycles, the strength of the trend in place, and the general economy to help set my stop.
One final issue to consider in setting your stops is whether to use a “mental stop” or actually set up your stops with your broker. At times market makers, the professionals responsible for completing each trade may push the price down to below support levels to force stops to execute. They do this to get shares to sell when the price goes higher. Of course, they are not supposed to do this, but it does seem to happen fairly often. There are two ways to overcome this problem. The first way is to set your stop sufficiently below the support level that your stop will not be caught in this trap. The other way is to use these stops as mental reminders for you to sell your shares. This requires discipline on your part to execute your trade and not hang on to your shares as the price keeps going lower. The choice is up to you.
Trailing stops are one of the most important tools you can use in your investing and trading. Be sure to use them either set them up with your broker, or, if you believe you have the discipline, then use them as mental stops.
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