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Trailing Stop/Stop-Loss Combo Leads to Winning Trades
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How the Trailing Stop/Stop-Loss Combo Can Lead to Winning Trades
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Glenda Dowie
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Glenda Dowie is the president/founder of Traderzone.com and president of APT Systems Inc. She has 9+ years of experience as an equities trader.
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Updated December 29, 2021
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Thomas Brock
Reviewed by
Thomas Brock
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Thomas J. Brock is a CFA and CPA with more than 20 years of experience in various areas including investing, insurance portfolio management, finance and accounting, personal investment and financial planning advice, and development of educational materials about life insurance and annuities.
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Online brokers are constantly on the lookout for ways to limit investor losses. One of the most common downside protection mechanisms is an exit strategy known as a stop-loss order, where if a share price dips to a certain level the position will be automatically sold at the current market price to stem further losses. Show
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Trailing-Stop/Stop-Loss Combo For Winning TradesTrailing StopsTraders can enhance the efficacy of a stop-loss by pairing it with a trailing stop, which is a trade order where the stop-loss price isn't fixed at a single, absolute dollar amount, but is rather set at a certain percentage or dollar amount below themarket price. Here's how it works. When the price increases, it drags the trailing stop along with it. Then when the price finally stops rising, the new stop-loss price remains at the level it was dragged to, thus automatically protecting an investor's downside, while locking in profits as the price reaches new highs. Trailing stops may be used with stock, options, and futures exchanges thatsupport traditional stop-loss orders. Workings of a Trailing StopTo better understand how trailing stops work, consider a stock with the following data:
If the market price climbs to $10.97, your trailing stop value willrise to $10.77. If the last price now drops to $10.90, your stop value will remain intact at $10.77. If the price continues to drop, this time to $10.76, it will penetrate your stop-level, immediately triggering a market order. Your order would be submitted based on the last price of $10.76. Assuming that the bid price was $10.75 at the time, the position would be closed at this point and price. The net gain would be $0.75 per share, less commissions, of course. During momentary price dips, it's crucial to resist the impulse to reset your trailing stop, or else your effective stop-loss may end up lower than expected. By the same token, reining in a trailing stop-loss is advisable when you see momentum peaking in the charts, especially when the stock is hitting a new high. Revisiting the aforementioned example, when the last price hits $10.80, a trader can tighten the trailing stop from $0.20 to $0.11, allowing for some flexibility in the stock's price movement, while ensuring that the stop is triggered before a substantial pullback can occur. Shrewd traders maintain the option of closing a position at any time by submitting a sell order at the market. The Best of Both WorldsWhen combining traditional stop-losses with trailing stops, it's important to calculate your maximum risk tolerance. For example, you could set astop-loss at 2% below the current stock price and the trailing stop at 2.5% below the current stock price. As share price increases, the trailing stop will surpass the fixed stop-loss, rendering it redundant or obsolete. Any further price increases will mean further minimizing potential losses with each upward price tick. The added protection is that the trailing stop will only move up, where, during market hours, the trailing feature will consistently recalculate the stop's trigger point. Using the Trailing Stop/Stop-Loss Combo on Active TradesTrailing stops are more difficult to employ with active trades, due to price fluctuations and the volatility of certain stocks, especially during the first hour of the trading day. Then again, such fast-moving stocks typically attract traders, because of their potential to generate substantial amounts of money in a short time. Consider the following stock example:
In the chart above, we see a stock in a steady uptrend, as determined by strong lines in the moving averages. Keep in mind that all stocks seem to experience resistance at a price ending in ".00m" and also at ".50," although not as strongly. It's as if traders are reluctant to take it to the next dollar level. Our sample stock is Stock Z, which was purchased at $90.13 with a stop-loss at $89.70 and an initial trailing stop of $0.49. When the last price reached $90.21, the stop-loss was canceled, as the trailing stop took over. As the last price reached $90.54, the trailing stop was tightened to $0.40, with the intent of securing a breakeven tradein a worst-case scenario. As the price pushed steadily toward $92, it was time to tighten the stop. When the last price reached $91.97, the trailing stop was tightened to $0.25 from $0.40. The price dipped to $91.48 on small profit-taking, and all shares were sold at an average price of $91.70. The profit (before commissions) was $942, or 1.74%. For this strategy towork on active trades, you must set a trailing stop value that will accommodatenormal price fluctuations for the particular stock and catch only the true pullback in price. This can be achieved by thoroughly studying a stock for several days before actively trading it. Next, you must be able to time your trade by looking at an analog clock and noting the angle of the long arm when it is pointing between 1 p.m. and 2 p.m., which you'll want to use as your guide. Now, when your favorite moving average is holding steady at this angle, stay with your initial trailing stop loss. As the moving average changes direction, dropping below 2 p.m., it's time to tighten your trailing stop spread (see above chart). The trailing stop/stop-loss combo eliminates the emotional component from trading, letting you rationally make measured decisions based on statistical information. Trader RiskTraders face certain risks in using stop-losses. For starters,market makers are keenly aware of any stop-losses you place with your broker and can force a whipsaw in the price, thereby bumping you out of your position, then running the price right back up again. Also, in the case of a trailing stop, there looms the possibility of setting it too tight during the early stages of the stock garnering its support. In this case, the result will be the same, where the stop will be triggered by a temporary price pullback, leaving traders to fret over a perceived loss. This can be a tough psychological pill to swallow. The Bottom LineAlthough there are significant risks involved with using trailing stops, combining them with traditional stop-losses can go a long way toward minimizing losses and protectingprofits.
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Related Terms
Trailing Stop Definition and Uses
A trailing stop is a stop order that tracks the price of an investment vehicle as it moves in one direction, but not in the opposite direction.
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Stop-Loss Order Definition
Stop-loss orders specify that a security is to be bought or sold when it reaches a predetermined price known as the spot price.
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Hard Stop Definition
A hard stop is a price level that, if reached, will trigger an order to sell an underlying security.
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Gapping
Gapping is when a stock, or another trading instrument, opens above or below the previous days close with no trading activity in between.
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Order-Triggers-Two (OTT) Definition
An Order-Triggers-Two (OTT) condition is a contingency whereby when a primary order is filled, two secondary orders are placed as a result.
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What Is a Setup Price?
A setup price is an investor's predetermined point of entry that, once breached, initiates a position in that specific security.
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