The Stop Loss
A stop-loss order is a popular trading tool for protecting investors against a drop in the price of a security. It gives an investor the opportunity to limit the amount of money that can be lost in case a security’s price falls. The investor first needs to determine the price at which the investor would want to exit the position to prevent further losses. Once the price is determined, the investor places a stop-loss order with the broker. If the market price of the security falls and reaches the stop-loss price, the stop-loss order becomes a market order, and a sale of the security is triggered.
A stop-loss order can be either a trailing stop-loss order or a regular stop-loss order. Their function is the same, i.e. to limit the amount of money lost in case of a price fall, but they work differently. A regular stop-loss order is straightforward: the indicated stop-loss price is fixed and does not change unless the order is modified by the investor. The trailing stop-loss order, however, is a more flexible trading tool. The stop-loss price on a trailing-stop order moves with the market price. If, once such an order is entered, the market price falls and reaches the stop-loss price, the order will work in the exact same way as a regular stop-loss order. However, if the market price of the security increases instead of falling, the stop-loss price is adjusted upwards accordingly, which preserves the advantage of protection against loss, while giving the investor a way to participate in and benefit from the price increase.
The following example will help to illustrate the advantage of a trailing stop-loss order. A trailing stop-loss price parameter can be expressed either as a percentage (e.g. 5%) or as a dollar amount (e.g. a spread of 35 cents). Whatever the method, if the price of the security in question increases, the stop-loss price will follow the increase and will be recalculated with the same parameters (5% or $0.35) based on the day’s high for that security. Once the stop-loss price is recalculated and adjusted upwards, it will not go below that amount. It can only be adjusted higher. If the market price falls and reaches the recalculated stop-loss price, the stop-loss order will be triggered.
To recap, a regular stop-loss order and a trailing stop-loss order are both designed to minimize a trader’s risk and set a floor to his exposure in a position in case of a price fall. A regular stop-loss order is the more inflexible of the two. If a trader wants to readjust the stop-loss price on a regular stop-loss order, he has to do so manually. With a trailing stop-loss order, the price is adjusted automatically in case of a price increase, moving with the new highs set by the market price, giving the trader an opportunity to participate in the increase, while saving the trader valuable time by allowing him to focus on more stocks, since there is no need to worry about the manual readjustment of trailing stop-loss orders.
The Advantages of a trailing stop
The one big advantage of using a trailing stop is that you have limited exposure to losses in case of a fall in the price of a security and unlimited exposure to profits in case of a rise. Trailing stops can also be used for a number of different security types: stock, option, and futures exchanges that can facilitate traditional stop-loss orders are able to do the same thing for trailing stop-loss orders.
The Best of Both Worlds
To get the best out of stop-loss orders, it is possible to combine a trailing stop-loss order and a traditional stop-loss order. You can do it by placing two stop-loss orders on a security: one a regular stop loss, the other a trailing stop loss. There are two important caveats. First, your trailing-stop price should be below the price of your regular stop-loss order. Second, you should have an idea of how much money you are willing to lose on a given position, and the regular stop-loss price should reflect it.
We will provide another example for the sake of clarity. You can set your regular stop loss at 2%. The trailing stop can be set at 2.5%. If the price of the security goes up, your trailing-stop price will move up with it. Once the trailing-stop price goes above your regular stop-loss price, the regular stop-loss order has outlived its purpose. You should now cancel it. If the price appreciation continues, the amount of money you can lose on this position decreases as the market price continues to go up. The idea here is to let the market price of the security move around a bit so that it can find a level of support, allowing you trail the increase in the price without being catapulted out of the position prematurely, and give the market price some flexibility to fluctuate as it seeks to find its support and build momentum.
The additional salient protection here is that your trailing stop-loss order will never move down, only up. The stop-loss price will be constantly recalculated during every trading session to reflect any upward movement in the price of the security as needed. If the market price does not change, your stop-loss order will be unaffected. That way you have the best of both worlds.
You can improve your manual or automated trading strategy using Trailing Stop ToolKit