When to Use Trailing Stops for Your Investments in the Stock Market
Trailing stops are an important technique in wealth preservation for seasoned stock investors and can be one of your key strategies in using stop-loss orders.
A trailing stop is a stop-loss order that an investor actively manages by moving it up along with the stock’s market price. The stop-loss order “trails” the stock price upward. As the stop-loss goes upward, it protects more and more of the stock’s value from declining.
Imagine that you bought stock in Peach Inc. (PI) for $30 a share. A trailing stop is in place at, say, 10 percent, and the order is GTC (presume that this broker places a time limit of 90 days for GTC orders). At $30 per share, the trailing stop is $27.
If PI goes to $40, your trailing stop automatically rises to $36. If PI continues to rise to $50, your trailing continues along with it to $45. Now say that PI reverses course (for whatever reason) and starts to plummet. The trailing stop stays put at $45 and triggers a sell order if PI reaches the $45 level.
In the preceding example, the investor uses a trailing stop percentage, but trailing stops are also available in dollar amounts.
For example, say that PI is at $30, and he puts in a trailing stop of $3. If PI rises to $50, the trailing stop will reach $47. If PI then drops from this peak of $50, the trailing stop stays put at $47 and triggers a sell order if PI actually hits $47. Trailing stops can help you sleep at night . . . especially in these turbulent times.
William O’Neill, founder and publisher of Investor’s Business Daily, advocates setting a trailing stop of 8 percent below your purchase price. That’s his preference. Some investors who invest in very volatile stocks may put in trailing stops of 20 or 25 percent.
Is a stop-loss order desirable or advisable in every situation? No. It depends on your level of experience, your investment goals, and the market environment. Still, stop-loss orders (trailing or otherwise) are appropriate in many cases, especially if the market seems uncertain (or you are!).
A trailing stop is a stop-loss order that you actively manage. The stop-loss order is good-til-canceled (GTC), and it constantly trails the stock’s price as it moves up. To successfully implement stop-loss orders (including trailing stops), you should
Realize that brokers usually don’t place trailing stops for you automatically. In fact, they won’t (or shouldn’t) place any type of order without your consent. Deciding on the type of order to place is your responsibility. You can raise, lower, or cancel a trailing stop order at will, but you need to monitor your investment when substantial moves do occur to respond to the movement appropriately.
Change the stop-loss order when the stock price moves significantly. Hopefully, you won’t call your broker every time the stock moves 50 cents. Change the stop-loss order when the stock price moves around 10 percent.
For example, if you initially purchase a stock at $90 per share, ask the broker to place the stop-loss order at $81. When the stock moves to $100, cancel the $81 stop-loss order and replace it at $90. When the stock’s price moves to $110, change the stop-loss order to $99, and so on.
Understand your broker’s policy on GTC orders. If your broker usually considers a GTC order expired after 30 or 60 days, you should be aware of it. You don’t want to risk a sudden drop in your stock’s price without the stop-loss order protection. Make a note of your broker’s time limit so that you remember to renew the order for additional time.
Monitor your stock. A trailing stop isn’t a “set it and forget it” technique. Monitoring your investment is critical. Of course, if the investment falls, the stop-loss order prevents further loss. Should the stock price rise substantially, remember to adjust your trailing stop accordingly. Keep raising the safety net as the stock continues to rise. Part of monitoring the stock is knowing the beta.