Trailing Stops: A Useful Tool for Investors’ Peace of Mind

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timthumbInvestors of all levels of experience are beset with a number of fears. They fear losing money in the first place. Once they have gains, they fear both missing out on future gains by selling too soon and losing the gains they’ve accumulated by holding too long. 

This is where trailing stops come in!

Some investment advisors recommend complicated options strategies for minimizing risk, but these incur additional costs and are hardly suited to the novice. More commonly, advisors recommend “setting stop loss orders” on stocks. This can be done in one of two ways—either by setting a specific dollar amount which would trigger a sale, or specifying that the stock should be sold if it drops by a specific percentage.

THE 10% RULE IS TOO SIMPLE FOR TRAILING STOPS

You will sometimes see financial “experts” recommend putting 10% trailing stops on all your stocks, micro caps included, but this is not necessarily the best advice. It’s common for more volatile issues to fluctuate by as much as 20% over the course of a few weeks or months, so such stop orders often do more harm than good.

A temporary hiccup in the market will almost guarantee a 10% loss on most of your stocks, even if you had modest gains up to that point. Trailing stops are much more useful tools. Although they will still execute if set too tightly, they will execute at a higher price in many cases, minimizing losses and retaining gains.

TRAILING STOP ORDERS EXPLAINED

Trailing stops work by raising the stop price whenever the price of the stock rises. For example, if you buy a stock for $100 per share, and set a 10% stop, the stop will execute if the stock drops to $90. But if the stock rises to $110, the stop price will rise to $110-$11 (10%) = $99. If the stock price rises a little more, you begin to lock in gains.

ADVANTAGES OF TRAILING STOPS

The advantages are obvious: As long as the stock price continues to rise, you continue to ride it up, but a specified drop triggers a sell. This both limits losses and locks in gains. It is especially useful when your stocks have huge gains, but you aren’t sure whether the rise is over.

If the stock drops immediately, trailing stops behave exactly the same as a regular stop order. But if the stock rises and then falls, you wind up with a smaller loss or no loss at all. It is also helpful if you are too busy to be tied to a computer screen or plan to be away on vacation and unable to keep tabs on all your stocks.

Trailing stops loss will mind your business for you. In a market that’s getting frothy, they may allow you to capture a bigger share of the gains than ordinary sell orders.

PROBLEMS WITH TRAILING STOPS

Although trailing stops are very useful investing tools, they are not perfect. If the company suddenly releases bad news or the market is going through a period of excess volatility, the price of a stock may drop very rapidly. In that case, it may be impossible for your broker to execute your order at the specified price and you may lose much more than you anticipated.

For that reason, it is better to sell outright if you have reason to believe that your stock’s best days are over or if it has gotten seriously overvalued.

You must also keep in mind that trailing stops set too tightly will execute sooner rather than later, resulting in the loss of good stocks that are simply experiencing some volatility. This results in trading costs to buy the stocks back and also incurs unwanted capital gains taxes, unless the stock is held in a retirement account. Thus, you must think carefully about where to set your stops. The best way to do this is to take the volatility of the individual stock in mind.

MEASURING VOLATILITY

The volatility of a stock is measured by a number called the beta, which is available on many financial websites. A stock with a beta of 1 is as volatile as the S&P 500, while one with a beta of 1.5 is 50% more volatile. Stocks with negative betas tend to have a negative correlation with the overall market, but the more negative the number the bigger the potential fluctuation. Stocks with higher betas need looser stops than those whose price fluctuates more mildly. Generally, large companies with stable balance sheets fluctuate less than new issues and small companies.

TRAILING STOCKS SUMMARY

Trailing stops are a useful tool for potentially locking in stock market gains and limiting losses. But they should never be used mindlessly. Use trailing stops when you are uncertain about the future prospects of your stock or if you could potentially maximize your gains. When you determine that your company is declining or overpriced, sell outright and move on.

Research and Editorial Staff
Mike Casson
Executive Editor
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