Trailing Stop/Stop-Loss Combo Leads to Winning Trades

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Trailing Stop/Stop-Loss Combo Leads to Winning Trades

Online brokers are always looking for new strategies to reduce investor losses. One of the most typical downside protection techniques is a stop-loss order, which states that if a share price falls below a specified level, the position will be immediately sold at the current market price to prevent additional losses.

Key Takeaways

  • With a stop-loss order, if a share price dips to a certain set level, the position will be automatically sold at the current market price, to stem further losses.
  • Traders may enhance the efficacy of a stop-loss by pairing it with a trailing stop.
  • You can enter a trailing stop order where the stop-loss price isn’t fixed at a single, absolute dollar amount, but is rather set at a certain percentage or a dollar amount below themarket price.

Trailing-Stop/Stop-Loss Combo For Winning Trades

Trailing Stops

Traders may improve the efficiency of a stop-loss order by combining it with a trailing stop, which is a trade order in which the stop-loss price is placed at a percentage or dollar amount below the market price rather than a single, absolute dollar amount.

This is how it works. When the price rises, the trailing stop rises with it. When the price eventually stops climbing, the new stop-loss price stays at the level to which it was drawn, thereby safeguarding an investor’s downside while locking in gains as the price rises to new highs. Trailing stops may be used with regular stop-loss orders on stock, options, and futures markets.

Workings of a Trailing Stop

Consider the following data for a stock to better understand how trailing stops work:

  • Purchase price = $10
  • Last price at the time of setting trailing stop = $10.05
  • Trailing amount = 20 cents
  • Immediate effective stop-loss value = $9.85

Your trailing stop value will increase to $10.77 if the market price rises to $10.97. If the latest price falls to $10.90, your stop value of $10.77 will stay unchanged. If the price continues to fall, this time to $10.76, it will breach your stop-level, triggering an instant market order.

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Your order would be submitted at the current price of $10.76. Assuming the offer price at the time was $10.75, the position would be closed at this moment and price. The net gain would be $0.75 per share, excluding commissions.

During market declines, it’s critical to resist the need to reset your trailing stop, otherwise your effective stop-loss will be lower than intended. Similarly, reining in a trailing stop-loss is recommended when momentum is rising in the charts, particularly when the stock is making a new high.

In the previous example, when the final price reaches $10.80, a trader may tighten the trailing stop from $0.20 to $0.11, providing for some flexibility in the stock’s price movement while guaranteeing that the stop is activated before a significant retreat occurs. Shrewd traders may close a position at any moment by putting a sell order at the market.

The Best of Both Worlds

It is critical to assess your maximum risk tolerance when combining standard stop-losses with trailing stops. You may, for example, place a stop-loss 2% below the current stock price and a trailing stop 2.5% below the current stock price. As the share price rises, the trailing stop will outperform the set stop-loss, making it superfluous or outdated.

With each upward price tick, any more price rises will imply further limiting possible losses. The extra security is that the trailing stop will only go up, while the trailing feature will continually recalculate the stop’s trigger point throughout market hours.

Using the Trailing Stop/Stop-Loss Combo on Active Trades

Due to price changes and the volatility of some equities, trailing stops are more difficult to use with active transactions, particularly during the first hour of trading. However, such volatile stocks generally attract traders due to their ability to create large sums of money in a short period of time. Consider the following stock illustration:

  • Purchase price = $90.13
  • Number of shares = 600
  • Stop-loss = $89.70
  • First trailing stop = $0.49
  • Second trailing stop = $0.40
  • Third trailing stop = $0.25
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trailing stop-loss order.

Image by Sabrina Jiang © Investopedia2020

The stock in the chart above is in an uptrend, as indicated by the strong lines in the moving averages. Keep in mind that all equities seem to face resistance at a price ending in “.00m” and, to a lesser extent, at “.50.” It seems that traders are hesitant to push it to the next dollar level.

Stock Z, our example stock, was acquired at $90.13 with a stop-loss of $89.70 and an initial trailing stop of $0.49. The stop-loss was terminated when the price hit $90.21, as the trailing stop took over. As the final price hit $90.54, the trailing stop was reduced to $0.40 in order to ensure a breakeven trade in the worst-case scenario.

As the price slowly approached $92, it was time to tighten the stop. When the price hit $91.97, the trailing stop was reduced from $0.40 to $0.25. On slight profit-taking, the price fell to $91.48, and all shares were sold at an average price of $91.70. The profit (before commissions) was $942, or 1.74% of the total.

To make this approach work on current trades, you must select a trailing stop value that will tolerate typical price variations for the company while catching only the genuine price decline. This may be accomplished by extensively researching a stock for many days before trading it.

Next, you must be able to timing your transaction by glancing at an analog clock and noting the angle of the long arm between 1 p.m. and 2 p.m., which you will use as a reference. Now, if your preferred moving average remains stable at this angle, stick with your original trailing stop loss. When the moving average reverses and falls below 2 p.m., it’s time to tighten your trailing stop spread (see above chart).

The trailing stop/stop-loss combination removes the emotional component from trading, allowing you to make calculated judgments based on statistical data.

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Trader Risk

Stop-loss orders expose traders to particular dangers. For starters, market makers are acutely aware of any stop-loss orders you put with your broker and may cause a whipsaw in the price, knocking you out of your position and then driving the price right back up again.

In the event of a trailing stop, there is also the risk of setting it too tight during the early phases of the stock’s support. The outcome will be the same in this situation, where the stop will be triggered by a brief market downturn, leaving traders concerned about a perceived loss. This is a difficult psychological pill to take.

What Are Trailing Stops Used for?

A trailing stop is often utilized by traders who wish to either lock in gains or prevent losses from stretching to the downside.

Is It Better to Set a Trailing Stop As a Percentage or Fixed Amount?

Most traders choose percentages for trailing stops because they are easier to reconcile movements across securities (e.g., $1 may represent a 10% move in one stock but less than 1% in another). However, if you want to lock in a precise dollar amount of a deal, you should use a set price trailing stop.

Why Are Trailing Stops Effective?

Trailing stops are useful because they enable a transaction to remain open and profitable as long as the price moves in the investor’s favor. This may assist certain traders in dealing with the psychological effects of turbulent markets.

The Bottom Line

Although there are dangers associated with utilizing trailing stops, combining them with regular stop-losses may help to minimize losses and safeguard earnings.

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