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Minimizing Risk: How Trailing Stop Losses Can Enhance Your Investment Strategy
Avoid losses and protect your gains with trailing stop losses.
You took the time to research a great stock. You know it’s a winner. Now, you just have to wait and reap the gains. But, then, a problem appears. You have a job. You can’t watch the market all day to hit sell the moment the stock peaks. What do you do?
A popular solution is the trailing stop loss. A particular sell order that can protect your upside while limiting your downside. If you combine these with stock alerts, it can be a great duo to use.
This article will explain how trailing stop losses work and the advantages and disadvantages of incorporating this tool into your investing strategy.
What’s a Stop Loss?
Before discussing the trailing stop loss, let’s look at the normal stop loss just to see how they work. A stop loss is a stock sell order that only activates once a predetermined market price is reached. It’s a downside protection tool intended to set a hard limit for how much you can lose.
A stop loss is like an automatic sprinkler system in a hotel. Most of the time, it’s idle and ignored. But if the system detects a fire, the sprinklers are triggered, and the fire is put out. It might create some water damage, but it prevents the hotel from burning to the ground.
The same idea is true for a stop loss. Once you own a stock, you can submit a stop loss order for a specific price. If the stock price goes up, the stop loss is never triggered. If the stock price drops to the trigger price, the sell order is submitted, and you avoid further losses. You might lose some, but you won’t lose everything.
The problem with a traditional stop loss is that it must be set manually, which means you must constantly reset the trigger price as the stock price increases to protect your gains.
What’s a Trailing Stop Loss?
The trailing stop loss differs from the normal stop loss in one key way: the trigger price automatically resets as the stock price increases. In effect, the stop loss “trails” behind the stock price like the tail of a kite. If the stock keeps going up, the stop loss follows. The stop loss is triggered if the stock price decreases, and your gains are protected.
The trailing stop loss is like a rock climber’s safety rope. As they climb higher, they attach the safety rope to a new point, which limits how far they will fall in case of an accident. They are free to move upward but sets a “new bottom” with each new safety attachment.
Trailing stop losses work the same way. The trailing stop only goes up, never down.
To have access to this feature, you need to be sure to find brokers with trailing stop loss in their feature set. Not all systems will have it, so if you use trailing stop losses, check carefully before choosing a broker.
Stop Loss vs. Trailing Stop Loss Visualized
Consider this example. You bought 100 shares of XYZ at $10 per share, then wisely set a stop loss at $9 to protect yourself from disaster. The next day, the stock shot up to $20 per share, then crashed to $5.
Luckily, your stop loss triggered at $9, so you were spared extra losses but missed all those potential gains. And you didn’t notice this because it happened during the trading day while you were at work.
Consider the same scenario with a trailing stop loss set to trail the stock price by $1. This means when the stock peaked at $20, then crashed down to $5, your stop loss was triggered at $19, automatically handing you a significant profit.
Could you have squeezed out a little more gain had you been watching the chart like a hawk? Maybe. But the trailing stop loss allowed you to reap most gains with little effort.
Trailing Stop Loss Advantages & Disadvantages
Now that we know what trailing stop losses can do let’s break down the pros and cons of incorporating this tool into your trading strategy.
- Dynamic Adjustment. The main advantage of the trailing stop is the dynamic adjustment of the trigger price, which allows you to maintain downside protection while the stock price increases.
- Maximize Profits. The market doesn’t always move in our favor, so when it does, we need to do all we can to maximize our profits. A trailing stop loss helps to maximize profits while limiting downside risk.
- Manage Emotions. With real money on the line, making impulsive decisions based on fear or excitement is tempting. This is a bad strategy. The most successful traders always rely on a dispassionate, systematic approach. Trailing stop losses are essential to help automate trading and eliminate emotional decisions.
- Early Sell. Even though it’s automatic, there’s still an instinct to tinker with the trailing stop loss, like a fisherman impatiently reeling in his line. If the trailing stop is too close to the market price, the Sell might trigger too soon due to normal fluctuations rather than an actual price pullback. Still, a sale could be triggered even if you do everything right. That’s the risk inherent in the tool.
- No Guarantees. It’s important to note that the trigger is not a sale. The trigger causes the sell order to be submitted to the broker, but there’s no guarantee the sale will be made at the price you want – especially if a stock is in freefall. This is another risk inherent to this tool.
Tips for Implementing Trailing Stop Loss Orders
Here are some tips for setting up trailing stop losses and incorporating this tool into your current trading strategy.
When you set the trailing stop loss, you can decide to set it to “trail” the market price by a dollar amount or a percentage. Your choice will depend on your specific goals and situation as well as the volatility of the investment.
Most traders use percentages because they can be more broadly applied as a strategy to different stocks. However, if you just have a few stocks in play, a dollar amount might be more precise, predictable, and easier to deal with.
Next, you must decide how far back you want the trigger price to trail the stock price. This will come down to the stock’s volatility, your strategy, and your risk tolerance. Studying the stock’s historical trends is crucial to understanding normal fluctuations. Tracking your investments and portfolios is a crucial strategy profitable investors use.
⚠️ If the trigger price trails too close to the stock price, you might accidentally trigger a sale from a minor price fluctuation.
⚠️ If the trigger price is too far, you might miss out on significant gains after the stock price peaks.
Like Goldilocks, you have to find the distance that is just right for the stock and your goals.
When you submit your trailing stop loss order, you can set it as a Limit Order or Market Order. Remember, the trigger price is not necessarily the sale price. The trigger price activates the order, which is then submitted to the market.
The benefit of a limit order is that you know for sure what price the stock will sell at. The downside is that if the stock price is in freefall, you might not complete the sale as there may not be a buyer at that specific price, defeating the stop loss’s entire purpose.
With a market order, you can be reasonably sure the sale will go through if the trigger price is met, though the actual sell price might deviate significantly from the trigger price. It’s up to you to decide which order type is most suitable for your situation.
Combine With Traditional Stop Loss
A common strategy combines a trailing stop loss with a traditional stop loss. This provides a second layer of downside protection, mainly when opening your position.
The idea is to set a normal stop loss and a trailing stop loss below it.
If the price drops suddenly, you’re protected by the normal stop loss. As the stock price rises, the normal stop loss will be overtaken by the trailing stop loss, rendering the normal stop loss irrelevant.
Start Using Trailing Stop Losses in Your Investment Strategy
We hope you understand how trailing stop losses work and how they can fit into your investment strategy. This is a powerful tool that helps protect your gains automatically while also saving you time. It’s a win-win, so we highly recommend giving it a try.
The only real danger is you may end up selling too early. But, depending on your strategy and time horizon, it might not matter.
Remember, nobody can see the future. Better to automatically protect moderate gains rather than take an excess risk for a little more – especially for long-term investors.
Trailing stop losses should be in the toolbox of any serious investor.