Trailing stops are wonderful tools for investors to protect against significant 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.
How a Trailing Stop Percent Works
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. A limit order may not execute, as 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 of June 17, 2005, at the closing price of 53.30. Being a student of the market and a member of Trading Online Markets, you had set your trailing stop percentage at 4.8%. This is equivalent to $2.56, meaning your stop is set to $50.74. It is now June 23, 2005, and the price of XOM closed at 58.41. You currently have an unrealized profit of 58.41-53.30=5.11 per share, less any commissions and exchange fees. A nice 9.6% profit, yet to be realized. Your trailing stop percent has also risen with the share price to $55.61, still 4.8% below the highest trading price for XOM. Keep in mind the trigger price raises with each new high in XOM. On September 22, 2005, XOM achieved a high of $65.28. Assuming you kept the same percentage, your new stop price would be $62.15 (65.28 x (1-0.048)) = 62.15. On October 3, 2005, the share price of XOM fell below your trailing percent stop, triggering a sale of XOM for a very nice profit of $8.85 per share or 16.6% in 3 1/2 months.
Ways to Determine Volatility
The volatility of a security is at the heart of setting the trailing stop percent. There are two methods to determine the volatility of security used by investors. One approach is based on an indicator known as the Average True Range (ATR).
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 accurate range for your security. The true range is the greatest of the following:
- The difference between the current high and the current low;
- The difference between the current high and the previous low; or
- The difference between the current low and the previous close.
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 be 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 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. Besides, 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 downside 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. 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 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 too 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 September 22, 2005, XOM attained a high of 65.28. Assuming you kept the same percentage, your new stop price would be 62.72 (65.28 x (1-.039)) = 62.75. On October 3, 2005, your trailing percent stop would have been triggered for a very nice profit of $9.42 per share of 17.7% in 3 1/2 months. You can recalculate the average volatility difference each month. However, unless there is a definite change in the stock’s volatility, it usually is not necessary.
Steps to Setting a Trailing Stop Percent
Successful investors follow several simple steps when they set their trailing stop percent:
- Determine your tolerance for risk or how much am I willing to lose before closing the position. Think how much can I lose and still sleep well at night. This should give you an initial idea of where to place your stop.
- Before making a trade, good investors have an exit target in mind, where they expect to exit the position. This exit target depends on the time used by the investor. A day trader will have an exit target that is close to his/her entry price. An investor who intends to hold the position for several years will have a much higher exit target.
- Calculate the reward-risk ratio for the trade. The reward-risk is the ratio of what you believe you can gain in the trade (the exit target) vs. what you can tolerate losing. Most investors look for a reward-risk ratio of at least 2 to 1, while 3 to 1 is better. A 3 to 1 ratio indicates you expect to gain 3 points for every 1 point of loss you can tolerate.
- Calculate the volatility of security using either method discussed above. Be sure to use the time frame that fits the type of investor you are.
- Go back and think about your tolerance for risk. If you consider yourself about average, then use a multiplier of 2 to calculate the stop loss range. If you have a higher tolerance for risk, then increase the multiplier to 2.5 or even 3.0. On the other hand, if your tolerance for risk is lower, then reduce the multiplier to 1.5 or even 1. Multiple the volatility measure calculated in step 4 by your multiplier. Then divide this by the last closing price to derive your percentage stop. Experienced investors adjust the multiplier depending on the strength of the market, the strength of the sector, and the strength of the security.
- Recalculate your reward-risk ratio with your new trailing stop percentage to see if the reward-risk ratio is still at least 2.0 or within your preferred range. If it is not, then reassess the trade, as it is not providing the proper reward-risk tradeoff. Your stop-loss percentage may be too large for the potential reward.
- When your securities’ price reaches your exit target, you can either sell all or part of the position or just let the trailing stop close out the position for you. Some investors sell half of their position at the exit target to capture the profit. They let the trailing stop close out the remaining half, just in case the price keeps climbing.
The Bottom Line
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.
The Stock Watch List available to our Premium Members includes the trailing stop percentage for each stock. Also, the chart for each stock and ETF includes the Average True Range (ATR) indicator as a reference.
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