Trailing stops are superb tools for investors 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 price is to account for a security’s volatility. Properly placed, a trailing stop price 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 price is misaligned with the volatility of the share price.
How a Trailing Stop Price Works
A trailing stop price follows price movements by a set dollar amount, 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 your trailing stop price price, the position would close. Each time the share price reaches a new high, the trigger price adjusts according to the trailing stop price, 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 price 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 price, 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 price at 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 price has also risen with the share price to $55.61, still $2.56 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 trailing stop price, your new stop price would be $62.72 65.28 - 2.56 = 62.72. On October 3, 2005, the share price of XOM fell below your trailing stop price, triggering a sale of XOM for a very nice profit of $9.42 per share (62.72 - 53.30 = 9.42) or 17.7% in 3 1/2 months time.
Ways to Determine Volatility
The volatility of a security is at the heart of setting the trailing stop price. 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:
- 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 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.
Most investors double the ATR to derive their trailing stop price. This gives the price sufficient room to pull back more than the average true range and still act as a stop. 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. If you are less risk tolerant, then either use a smaller multiplier, such as 1.5 or do not use any multiplier, taking the aTF as your trailing stop price.
Stock charting services, such as stockcharts.com may include an ATR indicator, simplifying the ATR calculation. The watch list for our Premium Members includes the ATR and the suggest trailing stop price for each stock and Exchange Traded Fund (ETF) on the list.
Average Daily Volatility
Another way to set the trailing stop price is to use 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 price stop based on volatility. Again let’s use Exxon Mobil, this time for the month of July 2005. You still purchased XOM on June 17.2005 at $53.30. It is now August and you want to set a trailing stop price using the average daily volatility method.
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 price volatility, or 2.30. Subtract 2.30 from the low of 58.75 set your stop 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 achieved a high of 65.28. Assuming you kept the same stop price, your new trailing stop price would be 62.72 (65.28 - 2.30 = 62.98). On October 3, 2005, your trailing stop price would have been triggered for a very nice profit of $9.68 per share of 18.2% in 3 1/2 months time. You can recalculate the average volatility difference each month, however, unless there is a definite change in the volatility of the stock it usually is not necessary.
Steps to Setting a Trailing Stop Percent
Successful investors follow several simple steps when they set their trailing stop price:
- Determine your tolerance for risk, or how much am I willing to lose before closing the position. Think how much can I loose 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 period 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 to loose. 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 a 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 you 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. Experienced investors adjust the multiplier depending on the strength of the market, the strength of the sector and the strength of the security. using your chosen multiplier calculate the trailing stop loss price.
- Recalculate your reward-risk ratio with your new trailing stop price 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. It is possible your stop loss price is too large for the potential reward.
- When the price of your securities 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 price is a valuable tool for any successful investor or trader. By accounting for a security’s volatility, the stop loss price 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 out Premium Members includes the trailing stop price for each stock. In addition, the chart for each stock and ETF includes the Average True Range (ATR) indicator as a reference.