What Is A Trailing Stop Loss?

A trailing stop loss is a useful tool for those doing momentum based stock trading. It may be easiest to explain with an example:

On Monday John purchases 100 shares of stock at $100 per share (that’s $10,000.) He then immediately places a 10% “trailing stop loss” sell order on those 100 shares of stock. From the point of purchase 10% is of course $10 which when subtracted from $100 gives you the initial stop loss point of $90. If the stock goes straight down after purchase the trailing stop loss would cause the stock to be automatically sold at $90 but in this case that is not what happened.

The stock reached a high of $105 on that first day and closed at $102. The trailing stop loss percentage is calculated by the highest market price the stock reaches. So if it has reached a peak of $105 then the new trailing stop loss is set to 10% short of $105 which is $94.50 (multiply the stop loss percentage by the high price and then subtract that result from the high price.)

On Tuesday the stock goes up to $113 before falling back as low as $109 and finishing at $111. The new trailing stop-loss is calculated with the $113 high water mark. It is $101.70 which is now higher than the price that John bought the stock for. In other words the 10% stop loss has now locked him into at least some sort of positive gain on this stock.

On Wednesday the stock drops down to $109 before rallying to a new high on the close at $116. Again a new higher stop-loss is set, it is now $104.40, this means that if the stock drops down to $104.40, it will be sold at market price at that time.

On Thursday the stock has a huge gain and goes straight up to $147. This sets the new trailing stop-loss at $132.30 which of course locks in John for a substantial gain from his original investment.

On Friday the stock sees has a correction and falls down to the stop-loss point of $132.30 triggering a sale of the stock. It is sold at the market price of $132 and John made a 32% gain on this trade (that’s $3,200.) The stock finished at $144, barely off it’s high from the day before.

So you can see from this example (as unrealistic as it may be) what some of the positives and negatives of using a trailing stop-loss may be. The positive is that it minimizes risk and locks in gains, the negative is that you may get bounced out by some normal market corrections on a stock that is still on an overall uptrend.

Setting the exact percentage trailing stop loss percentage should depend on the history of the stock’s price flucuation and how much risk you are willing to take.

My personal strategy calls for a tight trailing stop loss in general because I believe in cutting losses fast and moving on to another stock that has momentum.

It’s important not to become too emotionally attached to your stocks or to think that it “has to go back up.” You must realize that it (the stock) doesn’t have to go back up, it may never go back up! Or it may take YEARS before it reaches the price you bought it at again.