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How to Place a Trailing Stop-Loss Order – Example, Pros & Cons

By Kurtis Hemmerling

trailing stop loss chartOne of the most difficult decisions investors have to make is when to take profits and when to cut losses short. Some traders will prematurely sell as a stock rises while others will hang onto their shares far too long as prices plummet.

How can you prevent from making the latter mistake? The trailing stop-loss order is one tool that can help you trade with discipline.

Let’s look at what the trailing stop-loss is, how it works, and the pros and cons of using it.

Trailing Stop-Loss Order

The trailing stop-loss order is actually a combination of two concepts. There is the “trailing” component and the “stop-loss” order.

A stop-loss order is when you specify a certain action to be taken at a certain price. If you buy a stock at $100 per share and you set up an order for the shares to be sold if prices dip to $90, you have placed a stop-loss order. You can set a stop-loss order at any value. Essentially, a stop-loss order is a form of investment risk management.

The problem with stop-loss orders is their lack of adaptability; they are static and do not move. For example, if your $100 per share stock moves up to $200 and the stop order stays at $90, your downside protection will be worthless.

The trailing stop-loss order adds in a dynamic component to overcome this hurdle. With the trailing feature, the stop-loss order is no longer fixed, but rather trails the price by a certain amount (usually a set percentage) that you specify. In doing so, one of the key advantages of the trailing stop-loss order is that it allows you to lock in profits rather than hold on to a stock for too long only to see your profits disappear.

trailing stop loss graph

One of the keys to a successful trailing stop-loss order is making sure to analyze the specific stock and its historical volatility. Don’t set an order that will likely be triggered by a stock’s normal daily price fluctuations or you will find yourself selling stock without good reason.

Another thing to keep in mind is that while the trailing stop-loss order price will automatically rise with share prices, it will never decrease. That is, the stop-loss order will always be based off of the stock’s highest price, which is usually calculated based on closing-day prices rather than intra-day prices.

Trailing Stop-Loss Example
You purchase shares of Xerox Corporation (NYSE: XRX) at $10 per share. You set the trailing stop-loss order at 5%. Thus, if the price falls to $9.50, your stock will automatically be sold. But as the shares of Xerox rise, so does your trailing stop-loss.

  • If share prices appreciate to $14, your trailing stop-loss order now sits at $13.30.
  • If Xerox rises to $20, your trailing stop-loss order will be at $19.
  • If the price jumps to $30 per share, the order is at $28.50.

Of course, you can set the value to any amount you like. This could be 1%, 5%, or 50%.

Advantages

  1. This order type will sell your stock automatically when share levels drop, giving you peace of mind when you’re away from your trading platform during any significant downward action in price.
  2. This order does not put a cap on profits. Shares can continue to rise and you will stay invested as long as prices do not dip by your predetermined percentage.
  3. The trailing stop-loss order is flexible. You can enter any trailing stop-loss percent for a customized risk management plan and change it as you please.
  4. There is no cost to placing a stop-loss order.
  5. This order allows investors to take emotions out of their trades and instead stick to predetermined goals.

Disadvantages

  1. There is no guarantee you will receive the price of your stop-loss order. If the stock price drops quickly, your order may not get filled at your predetermined stop price. Thus, you may be forced to sell at a lower price than you expected. This is particularly true with illiquid stocks or in fast-moving markets.
  2. Some brokers will not allow for stop-loss orders for specific stocks or exchange-traded funds (ETFs).
  3. Extremely volatile stocks are difficult to trade with trailing stop-loss orders. If you set an order too low to account for these potential fluctuations, you are liable for significant losses. But if you set the order too high, you may end up unwillingly selling the stock due to normal daily price movements at a time when you might be better off holding onto the stock.
  4. You lose the ability to make a thoughtful and analytical decision whether to sell the stock after a price drop when you might otherwise deem the drop irrational.

Final Word

The trailing stop-loss order is an effective tool, when used wisely, and it can help you gracefully liquidate a position with either a profit or a limited loss. Before setting your order, make sure you take into consideration the overall volatility of the market and the stock, and whether you would like to be a short or long-term investor in the company.

Have you traded with trailing stop-loss orders in the past? What has your experience been like? In what situations do you feel these orders are most valuable?

(photo credit: Shutterstock)

Kurtis Hemmerling
Kurtis Hemmerling is a personal finance enthusiast that has been putting his passion into writing since 1998. His goal is to demystify the investment world to benefit the readership of Money Crashers.

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Comments

  • http://ArborInvestmentPlanner.com Ken Faulkenberry

    Kurtis, I love your writing. Your article is once again a balanced and articulate description of your subject. However, on this subject, I want to make an arguement that the case against using stop loss orders is strong, and most investors should rarely use them.
    Your list of disadvantages are extemely important and overwelm the advantages. Many people got burned very badly in the “flash crash” when the market dropped over 900 points and then recovered most of the loss in less than an hour. Many investors had stop orders executed near the low.
    I also have a philosophical problem with the advantages. Using stop losses basically means the investor is using momentum investing. Momentum investing was discredited (in my mind) after the 1990′s bull market that ignored valuation. Valuation matters! If I own a great stock and it drops 10% I want to buy more not sell it!
    Thanks for letting me voice my opinion.
    Ken Faulkenberry
    http://AAAMPblog.com

  • Kurtis Hemmerling

    I always appreciate a different viewpoint than the mainstream. I personally don’t use stop-losses and manage each stock on an individual basis. Here are the issues that concern some:

    Momentum still a very persistent effect as is borne out in the most recent Fama and French work (2011) – http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1720139 In every country around the world but Japan momentum is real. Past winners over 12 months turn into excess gain winners over the following 52 weeks. Smaller stocks have larger momentum associated gains. Momentum has been exploited in many profitable strategies (You can also see gains for each year) http://www.aaii.com/stock-screens/

    But what you say is true… when the market is volatile and trading sideways (but not necessarily in a bear cycle), having trailing stops is a good way to get kicked out of the market.

    Where trailing stops are useful is in bull markets, when you buy trending stocks and you only want to ride for a period of time and get out at the consolidation. At this point in time, trailing stop-losses can be good. Bull markets are far less volatile than any other market (as the VIX will show).

    Valuation is important if you do not believe in the efficient market hypothesis which states that all stocks are properly valued at all times based on all information. This is still the prevalent theory (which I disagree with somewhat). But if you are like Warren Buffett (and it seems that you are), then trying to value stocks and buying during market panics when valuations drop from historical averages or near intrinsic value and selling when valuations vastly exceed historical norms, makes trailing stop-losses… well point-less.

    So to sum up this already too long a post, I agree with you, but we may not be in the majority.

  • http://ArborInvestmentPlanner.com Ken Faulkenberry

    While I certainly would not argue with any successful momentum trader. The fact is one is a trader and one is an investor. The average investor, saving for retirement should not be involved in momentum investing!
    Thanks Kurtis!

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