How to Create a Stock “Safety Net” with Trailing Stops
Investing in stocks?
Worried about a crash?
Then you’ll want to know about a special kind of “sell order” called a “trailing stop loss.”
It’s one of the surest ways to ensure your gains and limit your losses.
You may be familiar with the term “stop loss,”which is a price point at which your brokerage account will sell a stock automatically.
For example, say you buy a particular stock at $40 per share. You can put a “sell order” for a particular stock into your brokerage account that says “sell this stock if it drops below $30.” If the price falls to that stop price, the stock is automatically sold for you.
A “trailing stop loss” is the same thing, just slightly more advanced.
A “stop loss” is a fixed sell price. But a “trailing stop loss” will follow a stock if the price moves upward, so your downside is protected no matter what happens.
Using stop losses helps you become a more rational investor in addition to helping protect your money. Stop losses can benefit those individual investors who typically have trouble deciding when to sell for a profit, which is most investors.
They have the mindset that they’ll surely sell at the right moment “if it drops to X,” then when unwanted events occur that thought turns into, "Maybe I’ll wait a few days and see what happens – it could go back up.” That’s when they hold onto the stock until it plummets, and they keep holding on just hoping it will go back up one day.
That’s why trailing stop losses are so useful. The above scenario can’t happen if you set your stops beforehand and allow your selling strategy to execute automatically.
Bottom line…
The idea behind these strategies is to remove emotion from the decision to sell a stock, whether that comes to locking in profits or protecting your investments in the event of a market crash.
Here’s how a trailing stop order looks in practice…
Say you bought 500 shares of GM at $50 per share. Now, the price is about $62, and you want to lock in a gain of at least 15% or about $9 per share, but you aren’t ready to sell the stock just yet.
To do this, put in a trailing stop. It can be based on a $ drop or a % drop.
A $ based trailing stop order looks like this:
And a % based trailing stop order looks like this:
[Notice that the key differences here involve the “ORDER TYPE” and the “TIME IN FORCE.” The order type lets you select the kind of trailing stop you want. The time in force lets you select whether you want this to be in effect just for today or for the foreseeable future.]
Once this order is placed, your brokerage will automatically sell your shares if the stock price falls below $59.
If you used a $ based trailing stop: [$62 (stock price) - $3 (trailing stop loss) = $59 (sell price)]
If you used a % based trailing stop: [$62 (stock price) * (1-.05 (trailing stop loss)) = $58.90 (sell price)]
Now, if the price of GM continues to go up, and the price grows to $70, your trailing stop order will automatically adjust. The new sell price for your $ trailing stop will be $67 and the new sell price for the % trailing stop will be $66.50. You would now be looking at a gain of about $17 per share.
If you used a $ based trailing stop: [$70 (stock price) - $3 (trailing stop loss) = $67 (sell price)]
If you used a % based trailing stop: [$70 (stock price) * (1-.05 (trailing stop loss)) = $66.50 (sell price)]
Trailing stops are great if you want to lock in some gains or protect your downside in the event of a crash.
No matter what happens, you win! And you get to sleep well at night.
The only time you do NOT want to use a trailing stop is with a stock that’s especially volatile (that means it moves a lot in a particular day). If you do, a stock could suddenly drop, you sell automatically, and then the stock starts ripping higher.
So use trailing stops on your bigger positions, your ETFs, and your stable stocks.
