Traders use various techniques to increase their profits and cut their losses. Two such techniques are stop-loss orders and trailing stop orders. Both types of stop orders allow you to specify the conditions that will automatically trigger an order to sell your position. By using them, you don’t have to be on hand to sell your position, which means you have some protection against sudden downswings.
Using an Exit Strategy
Whether you trade stocks, bonds or other securities, it is advantageous to have an exit strategy before you purchase your position. The reason is that an exit strategy allows you to reduce the emotional pulls of fear and greed. For example, you might want to avoid selling your position too soon, without giving prices enough room to fluctuate. If your exit strategy is to not sell your position until prices retreat, say, 10 percent, then you might avoid selling in a panic when prices fall 5 percent. Stop orders provide you a way to implement an exit strategy.
Manually Selling Your Position
At any time, you can enter, via an online trading platform or a phone call to your broker, an order to sell part or all of your position. If you want immediate execution, you enter a market order. With this type of order, the position is sold at the current bid price (i.e., the price a buyer is willing to pay). You have no control of the price you will receive with a market order, but you are guaranteed immediate execution.
If you would like to specify the minimum selling price you’ll accept, you enter a limit order. In this case, you guarantee that you’ll receive a price no less than the limit, but you have no assurance that the sell order will execute. You can enter a limit order ahead of time, but a market order requires you to enter it when you want it. However, you can use trading stops to pre-enter market orders that execute under conditions that you specify. You can set a limit order’s time in force to a single day or have it remain in place until it executes or you cancel it (i.e., a good-til-canceled order).
Understanding Stop-Loss Orders vs Trailing Stop Limit
A stop-loss order specifies that your position should be sold when prices fall to a level you set. For example, suppose you own 100 shares of XYZ stock currently trading at $90 per share. You want to sell your position if the stock falls to $87, so you enter a stop-loss order for $87. If at any time the price touches $87 or less, your broker will enter a market order. Note that you have no assurance that the price you receive will be $87. It will simply be the next available bid once the market order is entered.
If you prefer, you can enter a stop limit order, in which you specify a stop price to trigger the order and a limit price to specify the minimum price you’ll accept. For example, you might enter a stop limit order with a stop price of $87 and a limit price of $86. If the XYZ shares enter free-fall and quickly drop from $90 to $80, your sell order might not execute because the minimum price you’ll accept is $86.
Understanding Trailing Stop Limit
A trailing stop triggers when a security’s price falls by the trailing amount (i.e., a certain percentage or dollar amount). For example, you might order a trailing stop to sell your XYZ shares with a trailing stop loss percentage of 5 percent. It triggers when the stock moves down 5 percent from its most recent high. To illustrate, imagine XYZ stock has been in a steady uptrend that reaches a peak at $100 a share. Your 5 percent trailing stop would trigger a sell order if the XYZ shares fall to $95 or below. If you entered a trailing stop loss, the sell order at $95 will be a market order. However, you can instead use a trailing stop limit that includes a limit price you specify in advance.
You can enter a trailing stop using an absolute price movement, like $5, instead of a percentage. The effect is that as the position’s price rises, the trailing percentage remains a constant percentage below, whereas the percentage distance decreases with an absolute trailing amount. For example, if XYZ shares rise to $120, a $5 trailing stop would trigger at $115, which is a 4.2 percent drop. Had you entered a 5 percent trailing stop, it wouldn’t trigger until the shares drop 5 percent to $114.
Stop Loss vs Trailing Stop Limit
The major difference between the stop loss and trailing stop is that the latter is dragged upward by the trail amount as the position’s price rises. In the example, suppose XYZ shares recover after falling from $100 to $97 and rise above $100. Each new high resets your trailing stop price. To illustrate, if the stock rises to $105, your 5 percent trailing stop will trigger if the shares fall to $99.75. A stop loss set at, say, $95 remains in effect at that price regardless of the position’s price movement, unless you modify the stop loss order.
Updating Your Stop Orders
You can update your stop orders at any time by revising the stop price (and optionally, the limit price). If you entered a stop loss and the position gains value, you can move up the stop loss price by entering a new order. The new order will automatically cancel the old one. In this way, you can manually simulate the effect of a trailing stop order.
Often, traders will revise their trailing stops. For example, you can “tighten up your stop” by changing it from, say, 5 percent to 3 percent. You can also loosen your trailing stop. Of course, you can cancel any stop before it executes, although you will then have no automatic price protection should prices suddenly fall.
Understanding Buy Stops
Buy stops and buy trailing stops work in the exact reverse way from their sell counterparts. Buy stops and buy trailing stops are commonly used to protect short positions. For example, you can take a short position in XYZ shares by borrowing the shares from your broker and then selling them for the current price of $100. Eventually, you must repurchase the shares and return them to your broker. Short selling is a bet that prices will fall. You profit from the difference between the price you sold the shares and the price you pay to buy them back.
If you want to protect your short position against rising prices, you can enter a buy stop or buy trailing stop. For example, if you short XYZ shares at $100, you can enter a buy stop to trigger at, say, $103. Alternatively, you can enter a trailing stop of, say, 5 percent. If prices rise above $100, the trailing stop will trigger once the price hits $105. Your trailing stop price is pulled down by falling prices.
You can also use a buy stop to get into a position. For example, suppose you suspect that XYZ shares are underpriced at $100, but don’t want to buy them until the shares start rallying. You can enter a buy stop order at, say, $104, which will enter a market order to buy the shares once the shares hit $104. You can also enter a buy stop limit order if you want to specify the maximum price that you’re willing to pay should the stop limit execute.
Eric Bank is a senior business, finance and real estate writer, freelancing since 2002. He has written thousands of articles about business, finance, insurance, real estate, investing, annuities, taxes, credit repair, accounting and student loans. Eric writes articles, blogs and SEO-friendly website content for dozens of clients worldwide, including get.com, badcredit.org and valuepenguin.com. Eric holds two Master's Degrees -- in Business Administration and in Finance. His website is ericbank.com.