Trailing Stop Loss

In a way, almost every stop loss that is carried with an open position is a trailing stop loss. The price level that closes an open position is generally moved as either price or time advances. I will use a long position in our example. You and I buy a stock at $100 and we decide to place a sell stop below the market to protect our account, in case we are wrong about our investment decision.

Some traders and brokers use a flat percentage calculation for this stop price level. This is a mistake. A flat percentage stop assumes that every stock trades at the same level of volatility. They do not. The average price movement on a daily basis in stocks is about 1-3%. However, there are many stocks which may move on a daily basis more than 5 percent of their daily prices. This is especially true for active low priced stocks.

If I use a flat trailing stop loss of 10 percent, for most stocks, the stop loss would be about 3 1/2 days movement away from current prices. [If a stock moves 3% of its price a day and does this 3 days in a row, prices have moved 9 percent of its price.] This sell stop may be fine for a stock that moves 3% of its price per day, but what about a stock that moves 9 % of its price a day? Yes there are many stocks that move that much of their price in a single day. Such a stock could be stopped out in a single day’s move against your position. You could easily be stopped out, just to watch the stock move back higher after you are out of the trade.

Trailing stop losses are a money management tool not a forecasting tool. Trailing stop losses are called that because they trail behind current prices and move as time or price advances. They are used to “lock in profits”. This means they are used as a tool to protect an account financially. Trailing stop losses are generally kept so close to current price levels that they are easily “hit” during price corrections within a trend. While a profit may be insured by the use of a trailing stop, the use of a trailing stop loss can take a trader out of a major trend rather easily.

This is the problem with the trailing stop. The average market correction easily hits many types of trailing stops and the end result is that the trader misses a potential dynamic bull market by the use of such a money management tool. Traders may point to the bull market in IBM or AAPL, but a strict use of a trailing stop could have taken them out of those trends early in the game.

The use of stop orders to close positions is very complex. Quantitative research focuses on their affects over time and the end result risk-to-reward profile from the trade strategy. Here is what you do to see if your trailing stop loss is working for you. Plot your trail stop on a chart and see if the trailing stop is easily hit during normal market corrections within a bull market. Look at many examples of bullish trends. If you see that your trail stop is easily hit during the typical market corrrection, then you know that you will be taken out of most bull markets very easily. This means you may miss a major move.

www.traderscountryclub.com was created to help you with trading and investing. This site will launch soon and you can learn more about stops of all kinds, as well as other monoey management strategies. The use of trailing stops are a major topic within the education section. Happy trading.

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