What is a Trailing Stop Order?

A trailing stop is a type of stock order. It is designed to protect gains by enabling a trade to remain open and continue to profit as long as the price is moving in the investor's favor. However, if the price changes direction and reaches a certain level, the trailing stop order is triggered and the trade is automatically closed to prevent further losses.

For example, let's say you buy a stock for $100 and place a trailing stop order with a 10% trailing amount. This means that as long as the stock price remains above $90 (which is 10% less than the original purchase price), the trade will stay open. However, if the stock price falls to $90 or below, the trailing stop order will be triggered and the stock will be sold automatically to limit your loss.

How Does It Work?

Using the example provided, if you purchase a stock at $100 and set a trailing stop order with a 10% trailing amount, your stop price is initially placed at $90 (10% below the purchase price). Should the stock price rise to $120, the new stop price adjusts to $108 (10% below $120). If the stock price then reverses and hits $108, the trailing stop order triggers, and the stock is sold, protecting your gains.

Benefits of Using Trailing Stop Orders

• Automatic Adjustments: The trailing stop order adjusts automatically with changes in stock price, eliminating the need for manual order updates.
• Protects Gains: It shields profits by exiting your position if the stock’s price falls to the designated trailing stop level.
• Flexibility: It allows for potential profit growth without setting a limit on the upside.

Considerations

While trailing stop orders offer several benefits, there are factors to consider:

• Market Volatility: In highly volatile markets, a trailing stop order may trigger due to temporary price swings, potentially leading to an early exit from a position.
• Gap Risk: Stock prices can “gap” significantly from one trade to the next without hitting the trigger price, possibly leading to larger than expected losses.
• Dollar Amount vs. Percentage: Deciding between a fixed dollar amount or a percentage for the trailing stop can affect the order's sensitivity to price movements.

Setting Up a Trailing Stop Order

When setting up a trailing stop order, determine:

1. Trailing Amount: Decide on a fixed dollar amount or percentage that aligns with your risk tolerance and investment strategy.
2. Order Duration: Choose how long the order stays in effect. This could be until the end of the trading day or valid until canceled (GTC).

Conclusion

Trailing stop orders are a valuable tool for investors seeking to protect gains while providing room for additional profits. By understanding how to effectively use trailing stop orders, investors can navigate the complexities of the stock market with an added layer of risk management.

As with all investment strategies, it’s important to thoroughly evaluate your financial goals and risk tolerance before implementing trailing stop orders in your trading plan.