A stop-loss order helps you limit your losses or protect your profits. The difference between a regular and trailing stop-loss order is that the regular stop-loss must be changed manually, while a trailing stop-loss is adjusted automatically based on the amount or percentage you set.
Limiting Your Loss
When you buy a stock you expect it to go up, but if it instead goes down, you want to limit your loss by selling it if it declines below a certain point. For example, you buy XYZ at $27.50 and want to limit your loss to 10 percent, so you put in a stop-loss order to sell at $24.75. If XYZ declines to $24.75, your stop-loss will be triggered and your order will be executed at the next market price. If, on the other hand, XYZ advances in price, you will continue to own it.
Protecting Your Profit
At some point XYZ reaches $37 and stalls. You are not sure if it will continue to go up or turn back down. You don’t want to sell too early, nor do you want to lose your profit. So, you move your stop-loss to $34.90. Again, if XYZ declines to $34.90, you will be sold out of it – stopped out. If not, you will continue to hold it. You can continue to adjust your stop-loss upward as XYZ advances.
Automating the Process
Instead of manually adjusting your stop-loss order, you can enter a trailing stop-loss that will trail, or stay below, the current price by the amount you set, say, 5 percent. The stop-loss will be automatically adjusted each time XYZ makes a new high. For example, when it reaches $37, the trailing stop-loss will be automatically raised to $35.15.
Advantages and Disadvantages
A trailing stop loss saves you the time and effort of recalculating and changing your stops manually and takes the emotion out of decision making, but it has a higher probability of being triggered unnecessarily. Stocks are less likely to reach some price plateaus than others. A stock advances by making a series of higher highs and higher lows. The correct price to place a stop is right below the most recent low. In our example, you would place the manual stop 10 cents below the most recent low of $35. If XYZ triggers your stop, it may signal a change of direction from up to down, so you would want to sell. If not, there may be more upside and you would want to continue to hold your stock. However, XYZ can decline to $35.15, where your trailing stop will be triggered, as part of normal fluctuation, or pullback. It can then turn around and continue higher without you in it.
- U.S. Securities and Exchange Commission: Stop Order
- Technical Analysis of Stock Trends; Robert D. Edwards, et al.