How To Use Trailing Stops

March 27, 2013

How To

Trailing stop loss

What is a trailing stop?

Technical Definition - A stop loss order set at a percentage level below the market price for a long stock position. The trailing stop price is adjusted as the price fluctuates.

Practical Definition – This mechanism allows you to do three things:

  1. It allows you to let profits run without selling your position too soon.
  2. Allows you to cut your losses early to prevent catastrophic loss to your portfolio.
  3. Literally takes all the emotion out of investing, which prevents you from making a drastic mistake.

How A Trailing Stop Is Used

As always I like to simplify things as much as possible. There’s absolutely no need for big words or financial jargon. A trailing stop is a very straightforward and simple thing to implement in your portfolio today.

To use a trailing stop you will predetermine a percentage below your entry price that you are willing to lose. This could be 10%, 15% or 25% whatever you determine this will be your “pack up your bags and move on” price point. In other words, if the price falls below this price point it will set off an automatic trigger to sell. However, we all hope that the price of the stock moves upwards and when/if it does your trailing stop moves upwards as well.

Confused? Don’t worry let’s take a look at some examples.

In July of 2007 Sally conducted some initial research on Microsoft (MSFT) and concluded that the stock was a Dividend King and loved the idea of owning shares for the long term. She busted her tail working overtime for 2 months so she could invest the extra money into MSFT. When it was all said in done Sally was able to purchase shares of Microsoft for $26/share.

Microsoft stock chart - MSFT

Not too shabby! She set a predetermined trailing stop of 25% which put her initial stop price at $19.50. Having this information Sally knew no matter what happened if Microsoft fell below $19.50 she would sell automatically. Yes she would lose money, a little bit of pride and probably some self confidence as well but she would preserve whatever capital she had left in order to invest in another stock position.

Remember, Sally must still monitor this position on a regular basis in order to adjust her trailing stop appropriately. In November of 2007 there was a spike in Microsoft’s share price all the way up to approximately $32/share.

Microsoft stock chart - MSFT

Sally had been monitoring this move and therefore had to readjust her 25% trailing stop loss. Since the share price was now $32/share her new stop price was $24. Unfortunately for Sally in July of 2008 the share price of MSFT closed below $24/share which triggered an automatic sell of her entire position. This resulted in a 7.6% loss on her position.

This definitely isn’t what anyone hopes for but it is inevitable in investing and in all honesty will happen more often than you’d like. But let’s take one more look at how Microsoft performed after Sally was stopped out.

MSFT - Stock chart

Wow! Looks like Sally got out at the right time. She purchased her shares for $26 and MSFT ended up trading as low as $14 during the financial collapse. That was almost half the value of her current position. Now I know individuals from the “buy and hold” camp will argue that if she simply held onto her shares while purchasing more she would be above break even and at a profit. While I understand their argument I personally subscribe to the “I can’t tell the future” camp. I would much rather cut my losses and take my preserved capital somewhere else that can work more efficiently. For example, Sally would have sold for a 7.6% loss but would have had that capital available to invest in large blue chip stocks trading at fire sale prices during the financial collapse.

How I Use Trailing Stops

Like everything else in this world, blanket statements/advice often lead to disaster and I believe the same holds true for trailing stops. I know their has been a lot of deep data research on what percentage is the most profitable but here is how I determine what percentage my trailing stop will be:

10% Trailing Stop – I consider this a fairly tight trailing stop. I use this for speculative or highly volatile stock positions such as gold/silver stocks, etc.

15% Trailing Stop – This is my conservative trailing stop. I implement this positions that have experienced a significant gain in a short amount of time and I want to lock in profits or for small to mid cap stocks.

25% Trailing Stop – I use this trailing stop about 80% of the time. The majority of my investing portfolio is focused on long term holdings at extreme values therefore I am willing to let these positions “breathe” during corrections.

The number one thing that all investors should acknowledge and remember is that it’s far easier to determine how and when to purchase a stock but much harder to determine when to sell. Trailing stops eliminates this guessing game and ensures you are profitable or at the very least preserve your investing capital.

**UPDATE**

My apologies but a couple of you have pointed out a very important piece of advice that I forgot to include. You absolutely DO NOT want to enter your trailing stops into the market for these reasons:

  1. All of the big boys on Wall Street will be able to see your order and could potentially trigger it.
  2. You can potentially forget you entered the order.

It is better to keep a mental note of your stops and sell your position the next day if it is triggered.

Do you use trailing stops? If so what percentage works for you?

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34 Responses to “How To Use Trailing Stops”

  1. Alan@escapingmydebt Says:

    Now you are speaking my language. I wish I did not have this debt to keep me out of the market. Great ways to use your stops, I like the %’s you set up.

    Reply

    • Marvin Says:

      Debt can always be a burden but at least you recognize that and are paying it off diligently. Trust me, the extra capital you will have left over to sock away into investments will be extraordinary.

      Reply

  2. Money Beagle Says:

    More often than not, here’s how a trailing stop functions for me: 1) I buy a stock. 2) I setup a trailing stop. 3) Stock immediately starts falling. 4) Stock hits trailing stop number. 5) Stock is sold at my trailing stop price. 6) Stock immediately reverses direction and doubles in price.

    Reply

    • Marvin Says:

      I know that feeling all too often! Quite frankly it sucks but it means you are doing the right thing, I don’t know what percentage stop you are using but I might suggest looking at loosening it a bit or researching some technical analysis to find a better entry point.

      Reply

  3. Kurt @ Money Counselor Says:

    Appreciate this explanation Marvin, as I often get the various stock transaction lingo confused in my mind. I have used trailing stops, but mostly have had experiences like Money Beagle details. As an admittedly paranoid sort, I suspect conspiracy on the part of Wall St insiders like the Specialists who manage stock trading. Do you know: Do Specialists have visibility on trailing stop orders??

    Reply

    • Marvin Says:

      It’s very unfortunate but yes, the big boys on wall street can see your stop losses if you place an order. I apologize for not making that clear in my post. I absolutely NEVER put my stops into my brokerage account for this reason. I simply make a note on my stockcharts platform of where my stop is, then sell the next day if it is broken.

      Reply

  4. JC @ Passive-Income-Pursuit Says:

    I don’t use trailing stops right now, although I probably should. I’ll have to re-examine my portfolio to see where they’re appropriate. Since you say that most of your portfolio is in the 25% stop loss category, what’s your take on tightening the stop if one of the positions makes a big move up?

    Reply

    • Marvin Says:

      The majority of my portfolio is made up of Dividends Kings which I use the 25% stop for, additionally every time I am paid a dividend I subtract that from the stop price.

      For example:
      Entry point is $20
      Stop loss is now $15
      Stock pays $.25 dividend
      Stop loss is now $14.75

      Additionally I only tighten stops on speculative positions and I don’t take too many of those on anymore. I have found that trading options on speculative stocks is far more low risk and successful than buying the stock outright.

      Reply

  5. My Financial Independence Journey Says:

    If I was going to be a short term investor or or speculator, I would be all over trailing stops.

    Reply

  6. William @ Bite the Bullet Says:

    The fact that many people have trailing stops IMHO is what causes drops to be magnified. I’ve experienced what Money Beagle talks about: having a trailing stop “tripped” and then the stock goes back up before I can react.

    To compensate, I now have ridiculous buy orders, so when this happens to one of my long term stocks, it trips a bargain buy. I was out of the country on vacation in fall 2011 and came back to find I picked up some cheap stock while I was away.

    But your basic point is valid, and I agree that 25% is probably below the “premature trip” point.

    Reply

    • Marvin Says:

      Great idea, I know a couple people who put their orders and just let them sit. It’s because of this they were able to pick up shares of tremendous price during the flash crash.

      Reply

  7. Jose Says:

    Nice post! I am a HUGE fan of trailing stops and use them quite a bit. Read my recent post on stop losses and you’ll see why! Thanks for the post. Jose

    Reply

  8. Justin Says:

    This can be an important tool to help preserve some of your income when investing. We can’t be watching the markets every hour of the day and sometimes we just need to sell. Knowing how to use tools like this can really help to keep you from losing your shorts.

    Reply

    • Marvin Says:

      I have seen it time and time again, sometimes in seasoned investors. They fall in love with a company, believe in their mission, and become too attached. They see their position go from a 10% loss, 20% loss, 40% loss, so on and so forth. Sometimes you just have to let go and move on.

      Reply

  9. John S @ Frugal Rules Says:

    Great explanation Marvin! In my experience a lot of retail investors do not use trailing stops due to lack of knowledge. They get sold out and think of course the broker did something wrong and do not use them. That said, I think they can be a great tool to use in your investing strategy. I am not currently using any, but have in the past and will more than likely do so again in the future.

    Reply

    • Martin Says:

      John, I stopped using stops because i got sold out too often in high volatility market and many times I watched the stock going up without me and I got scared to jump back in because I got burned. So stops in reality didn’t work well for me and I wasn’t comfortable using them.

      Reply

    • Marvin Says:

      I have gotten burned on stops before only to find out that my initial analysis was right but my timing was lousy. When it comes to my large cap Dividend Kings I haven’t been stopped out of one. If I get stopped out of a position it’s always with my speculative positions.

      Reply

  10. Martin Says:

    For some reason trailing stop have never worked for me. In fact, none of the stops worked for me. Many times I bought a stock, set the stop loss, soon got stopped out and then the stock reversed and continued higher but without me. And I was setting the stop to 10% below the purchase price. In high volatility market the stops can kill you. So I stopped using them and rather use a mental stop if necessary. But with high quality dividend growing stocks you do not need stops at all I guess.

    BTW, I joined LinkedIn today as CEO of HelloSuckers Investments.

    Would you mind checking it out?
    http://www.linkedin.com/pub/martin-z/69/2a1/227

    If you do not like the link in the post, then edit it and delete it. But I got a bit excited about it.

    Reply

    • Marvin Says:

      I know how you feel Martin it’s the most frustrating thing ever! I have had many days of banging my head against the keyboard. This use to happen when I traded the Euro specifically. You are correct with dividend growth stocks using a 25% stop loss I have never gotten stopped out.

      Reply

  11. Executioner Says:

    The main risk of a trailing stop order is something like the Flash Crash of 2010. You could be sold out far below your stop price if the market moves downward quickly.

    http://en.wikipedia.org/wiki/Flash_crash

    I think the risk of trailing stops mostly outweigh the benefits. There are better hedging strategies out there, but a long-term investment horizon is probably the best.

    Reply

    • Marvin Says:

      I will have to update this article as you are the second person to mention this. It is imperative that YOU DO NOT enter your stops into the market. I use mental stops and if my stop is triggered the next day I sell my entire position.

      Reply

  12. Jim Says:

    Great post Marvin, wish I knew more about trailing stops about a year ago, when I took bath on a stock I was up on, then it plummeted! You live and learn, but this is great info, thanks!

    Reply

  13. Untemplater Says:

    It’s easy to get emotional with investing and make bad decisions off of that. Having ways like trailing stops to take the emotion out of trading can be really helpful ways to set targets and decide when to pull the trigger.

    Reply

  14. Glen @ Monster Piggy Bank Says:

    I always set myself trailing stops, they are a great way to ensure you don’t lose to much capital should a trade turn on you.

    As for everyone worried about the big boys hitting your stops… Get real! Unless you are playing with millions to billions like they are, then they couldn’t care less about your 5-10K parcels.

    Reply

    • Jean Says:

      I was thinking the same thing as Glen. The reason I would use a trailing stop is because I can get caught up in my care-taking responsibilities. If I place the stop, this might save me. If my investment is only about $3000-$4000, does entering the order really matter to the big boys?

      Reply

      • Marvin Says:

        Thanks for stopping by Jean. Definitely doesn’t matter to the big boys but if you share the same stop price as others that might make you a target.

        Reply

    • Marvin Says:

      Couldn’t have said it better myself Glen! Typically the big guys at wall street stops that have been established by investment newsletters.

      Reply

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