A trailing stop limit can be used to achieve an incredibly advantageous and intelligent position on a security, but it can also get you into trouble if you don’t set your limit appropriately. This latter point, of course, is the exact opposite of what a trailing stop is supposed to accomplish.
Here you will find a detailed explanation of trailing stops with examples and advice that cover smart trailing stops and unlucky (which does not necessarily mean unwise) trailing stops. If you haven’t already, you might consider informing yourself on call and put options with this introduction to options class so that you can tackle the market from all angles.
Trailing Stop Limit Explained
If you aren’t familiar with what a stop or stop order is, read this brief description so that you can understand the rest of this post.
A trailing stop is one that can be set at a certain price, or percentage, away from the current market price of a stock. There are two primary ways you can accomplish this, and you may have guessed them already: by going long or short. If you position yourself long, naturally you will set the trailing stop below the stock price; positioning yourself short means you will set the price or percentage above the stock price.
One of the hardest things to do in the stock market is sell. It’s easy to get greedy, to keep waiting, etc. But if you always sell when you’re ahead (or before you fall too low), then you can do a lot to protect yourself. A trailing stop means that when you set your percentage or price, you will automatically close the trade when the stock hits that price.
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Example: When All Is Well
Let’s look at an example where a trailing stop works like magic. Let’s say you buy a stock at $20. You might decide to use a trailing stop limit of 20%. Let’s also say that you want to establish a long position. This means that the trailing stop is set at 20% below the stock price. It’s important to note that the 20% “moves” with the stock. So if the stock jumps to $25, the trailing stop is now 20% below $25. In either case, if the stock drops 20%, the stop is triggered, the trade closes and you cannot lose any more money. Phew.
But let’s say the stock does jump to $25. And then, after a while, it jumps to $30. That’s a hell of a return, so at this point you would probably want to adjust your trailing stop. Fortunately you can do this. Now you tighten your limit to 10% to lock yourself into a sweet gain.
Now that we’ve got our new limit, we know the stock can only fall $3 before it’s triggered. If this happens, our trailing stop kicks in at $27 and we net ourselves a 35% gain, which anyone would be ecstatic about.
If you want to learn other ways to profit and take advantage of a falling stock, check out this free post on call and put options.
Example: When All Is Lost
At first, it looks like trailing stops are perfect. They allow you to gain money limitlessly and they pull the plug when your stock starts to fall. But this mindset can cause you to fall asleep on your stock and, if the conditions are right, you can still lose everything. Literally.
Let’s use our original example. We have a stock price of $20 and a trailing stop of 20%. The key to a trailing stop is that it resets when a day closes with a gain. So you could technically lose 10% (or anything less than 20%) one day, but then the next day the stock goes up by a few percentage points. In other words, the stock cannot close at a gain or it interrupts the loss. In this way, if you don’t pay attention to your option, the stock could fall 15% one day, rise 5% the next, and continue falling and rising, while never hitting 20%, until you have lost every penny.
The key, obviously, is to pay attention to your stock and to set the trailing stop so that it will most likely be triggered by a decline. It takes practice and, above all, attention. Educate and protect yourself on probabilities and strategies with this highly acclaimed Advanced Options Concepts simulation course.