What Is a Trailing Stop Loss (Order)?
A trailing stop loss order (or trailing-stop) is a special type of trade stop order that manages risk and offers profit protection. This exit strategy adjusts the stop price of a stock or stocks by a certain percentage below the market price.
For example, you can put a trailing stop of 10% on your investment, meaning that if the stock price dropped by 10%, your stock would be sold automatically. Thus, it offers you profit protection of not losing more than 10% of your investments.
How Does Trailing Stop Loss Work?
To understand how trailing stops work, it’s important to first understand the meaning of a stop-loss order. A stop loss order is a trade order given to a broker to buy or sell a stock when it reaches a specific price. It helps investors limit their losses and lock in profits with a pre-determined exit price.
A trailing stop loss differs in that it is a percentage (rather than a set dollar amount) that moves as the stock price moves. As the stock’s price moves up, the trailing-stop percent moves along with it. But if the stock price begins to decline after it’s moved up, the stop loss price remains at the last level.
Trailing Stop Loss (Order) Example
Let’s assume that you purchase 100 shares of XYZ Company at $100 each. You put in a trailing stop loss order for 5%. If the shares drop 5% below market price, you would automatically sell the shares.
Although you have every expectation that XYZ Company’s stock will rise, if it does move against you, you’ll have limited your financial losses to 5% of the total investment. This protects you and locks in profit. If, however, the stock price rises, you will benefit from the gains.
Let’s say that XYZ Company’s stock jumps in a month to $200 per share. This order will only trigger if the price dips below 5% of $200 ($190).
When to Use Trailing Stop Loss
Trailing stop losses are used for many reasons:
- Investors have the assurance that they’ll only lose a certain percentage of their investment should the price drop. If the price rises, however, they’ll benefit from the increase and still minimize their loss.
- A trailing stop loss can be put in place with most brokers or investing software and it will work automatically. You can also put one into place manually, but this is more common for traders who are always looking at their investments.
Trailing Stop Loss vs. Trailing Stop Limit
A trailing stop loss automatically sends a trade order when the loss limit is reached. A trailing stop limit, however, is an order for the broker to sell the stock if it reaches the limit (should the broker be able to find a buyer for the stock at the limit price). The order will only be fulfilled at the current limit price or better.
Trailing Stop Limit Example
Let’s use the same example of 100 shares of XYZ Company stock purchased for $100 per share. Instead of a trailing stop loss, the investor uses a trailing-stop limit. The investor sets a stop-loss for $1 below the maximum price and a limit of $0.50 below the stop-loss.
If the security is purchased at $100 per share, let’s assume it rises to $101 per share before dropping to $99 per share. This triggers the stop loss. Your broker now generates a limit order to sell the security. But unlike at trailing stop loss, there must be a buyer for the stock willing to purchase it at or above $98.50 (the $0.50 limit).
The Limitations of Trailing Stop Limit
In the trailing stop loss, the trade is automatic. In the trailing-stop limit, there must be a buyer willing to pay the specified limit price. If the stock price continues to fall, it is possible that the stock does not sell or that the order is only partially filled at the limit price ($98.50), even if the trade order is triggered. In that case, the investor is left with the stock, and an unrealized loss.
Traders and Trailing Stop Loss Risks
Investors must consider the percent given in the trailing stop order very carefully. For particularly volatile stocks, a small percent may trigger unnecessary sell orders, resulting in frequent trades. Investors may find that a too-low trailing stop loss results in wash sales.
Bear in mind that with each trade, you’re also paying your broker a fee to make the trade. Frequent trades (churning) increase fees and may result in higher than expected broker payments.
Lastly, frequent trading – especially stocks held for fewer than 30 days – can have considerable tax ramifications for investors. The tax rate for long-term capital gains is much lower than that of ordinary income, so it pays to hold onto investments (such as stocks) for long-term gain.
How to Trade with Trailing Stop Loss
A trailing stop loss order is like automatic downside protection. To set up a trailing stop loss, you will take the following steps:
- Call your broker and ask to set up a trailing stop loss order
- Discuss risk management and decide on the percentage you want to set the trailing stop loss order at
- Keep the order on file internally with the brokerage
The file is typically monitored between 9:00 am and 4:00 pm ET. If the stock prices drop below your trailing stop loss order percentage then it will trigger your broker to sell the stock automatically.
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