What Is A Trailing Stop Order?

Trailing Stop OrderOne of the hard parts of investing is knowing when to sell once you have a profit.  Another is selling too early and missing out on more profit.  And, of course, through all that, you still want to protect your profit so it doesn’t become a loss.  Which all sounds complicated, but a trailing stop order covers all of this and more.

Define Trailing Stop Order

A trailing stop order is just a stop order with a built-in trigger or trailing price.  Unlike a stop order that has a specific, fixed activation price, a trailing stop order has a moving activation price based on a stop parameter.  Once triggered, the trailing stop order becomes a market order and the stock is sold at the next best available price.  That stop parameter can be set one of two ways:

  • By Price -as a dollar amount.
  • By Percentage - as a percentage of the current price.

Please don’t confuse price with percent when placing an order.  There is a big difference between 10% and $10.  And can lead to lower profits or even a loss.

Trailing Stop Sell Order

A trailing stop sell order is used for long positions.  It helps limit your losses in a falling market but still maximize and protect your profits in a rising market.  The best way to explain it is with a couple of examples:

You own 100 shares of stock ABC now trading at $50.  You have a nice profit already but think the stock’s price can still go higher.

  • By Price – You place a trailing stop order with a $5 trailing price.  Which means at the current $50 price, if the stock drops to $45 ($5 below the current $50 price) the stop order is activated, becomes a market order and is sold.  However, if the stock price rises, that $5 trailing price follows along.  When the stock rises to $60, the new activation price becomes $55 ($5 below the $60 stock price).  If the stock rises to $70, the activation price becomes $65 (again $5 below the $70 stock price).  And so on, for as long as the stock price rises.
  • By Percentage – Or you place a trailing stop order with a 10% trailing price.  What that means is, at the current $50 price, if the stock drops to $45 (10% below the current $50 price) the stop order is activated, becomes a market order and is sold.  However, if the stock prices rises, the 10% trailing price follows along.  When the stock is at $60, the activation price becomes $54 (10% below $60).  If the stock hits $70, the activation price becomes $63 (10% below $70).  And so on, for as long as the stock price rises.

As you can see, a trailing stop sell order protects you from a falling stock price without limiting potential profits.  As the stock price rises the trailing activation price rises with it.  But when the stock price falls, the activation price doesn’t change.

Trailing Stop Buy Order

A trailing stop buy order is used when short selling a stock.  It helps limit your losses in a rising market but still maximize and protect your profits in a falling market.

With short selling you borrow stock and sell it at a high price, with the goal of buying it back at a lower price.  The difference becomes your profit.  Again, here’s a couple of examples:

You previously borrowed and sold 100 shares of stock ABC now trading at $50.  You have a nice profit already but think the stock’s price can still go lower.

  • By Price – You place a trailing stop buy order with a $5 trailing price.  At the current $50 stock price, if the stock rises to $55 ($5 above the current $50 price) the stop order is activated and the stock is bought.  However, if the stock price continues to fall, say to $40, the trailing price follows.  At $40 the activation price becomes $45 ($5 above the $40 stock price).  At $30, the activation price becomes $35 (again, $5 above the $30 price).  And so on.
  • By Percentage – Or you place a trailing stop buy order with a 10% trailing price.  At the current $50 stock price, if the stock rises to $55 (10% above the current $50 price) the stop order is activated and the stock is bought.  However, if the stock price falls to $40, the 10% trailing price tags along.  At $40 the activation price becomes $44 (10% above the $40 price).  At $30, the activation price becomes $33 (10% above the $30 price).  And so on.

As you can see, a trailing stop buy order protects you from a rising stock price without limiting any potential profits.  As the stock price falls, the trailing activation price falls with it.  But when the stock price rises, the activation price doesn’t change.

The type of trade you use is just as important as what you buy and sell.  A trailing stop order allows you to limit your losses without sacrificing gains.  Since timing the market is nearly impossible and sticking to a strategy is even harder.  A trailing stop order, when used correctly, is the next best thing.

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