Foreword
In this article, we take a look at a set of special tools used by professional stockbrokers and lay retail investors alike. The simplicity behind this type of technical trading instrument can mislead on just how significant an effect it can have on your portfolio. Let’s quickly explore the use of trailing stop orders as an order type as part of an effective entry/exit strategy when trading securities.
“Take calculated risks. That is quite different from being rash.” - General George Patton
Definition
Moving averages are one of the core indicators in technical analysis, and there are a variety of different versions. SMA is the easiest moving average to construct. It is simply the average price over the specified period. The average is called "moving" because it is plotted on the chart bar by bar, forming a line that moves along the chart as the average value changes.
Stop orders are orders to buy or sell a security when its price moves past a specified point in the market. They can either be stop loss, which is an order to sell should a stock fall below a specified price or buy stop, which is an order to buy a stock once it has risen to a particular price. A multitude of reasons and theories exist as to why a trader might want to utilize either one of these tools. However, if stop orders themselves can be thought of objective, specific orders, trailing stop orders can be thought of as their subjective, relative cousins.
Trailing stop orders are set relative to the price of a security at the points of entry/ purchase or exit/sale. For a long position, an investor places a trailing stop loss below the current market price of a stock by a fixed price or percentage difference. Inversely, for a short position, one places the trailing buy stop above the current market price by a fixed price or percentage difference.
Mitigating losses and capitalizing on gains
Trailing stop loss orders help to mitigate loss made in the acquisition of a security and protect any potential gains made by setting a relative price or percentage change at which to sell, otherwise known as the trailing amount. For example, say one acquires $100 worth of stock in company ABC. A trailing stop loss order can be set to sell the security should it lose up to 10% of its most recent value. This means that should the value after the purchase of the security drop 10% to $90 a market order will be triggered and your ask of $90 dollars will be automatically made by your brokerage. However, for every increase in price, the relative price for this trailing figure increases. In our example let’s assume the price of stock ABC is in a steady upward trend and eventually reached $110. The trailing amount remains the same from the initial order, but now the sell order will be triggered should the price of the security fall to $99. Effectively as an investor one would have benefitted from the potential for a price increase but minimized their loss from their initial investment to $1, or 1% of the initial sum.
Protecting gains and managing risk
Inversely, trailing buy-stop orders are used to protect short positions. With stop loss orders, the trailing amounts (percentage or price difference) are below the trigger value. With these, the trailing amounts are above the trigger value. A trailing buy stop order can be set to buy a stock should its current value rise by a fixed amount or percentage.
These can be used to enter a position if it is suspected that a stock is currently undervalued. To be sure investors typically wait for this hunch to be confirmed by a short-term price hike. Let us look again to stock ABC from earlier, currently valued at $100. An investor, determining this to be an undervaluation based on information from either historic moving averages or knowledge based on other external factors, can decide they wish to acquire this stock. One can use a trailing buy-stop to acquire more shares should the security rise by 15% to $115, for example. Remember that the trailing stop price is pulled down by falling prices.
This tool is also useful when short selling. Supposing you are short-selling a stock, you can protect the position against rising prices by entering a trailing buy stop. If one were to short stock ABC for example one could enter a buy-stop to trigger at $105 or make a safer bet of setting a trailing buy stop of 5% from the current price.
Entry/exit strategy
One notable advantage of trailing stop orders over regular stop orders is their adjustability according to market conditions. Relying upon information derived from other robust technical analysis tools like EMAs and RSIs, trailing stop orders serve as mechanisms for effective entry and exit strategies. For example in a particularly bullish period on the market, one might want to protect an investment from a potential reversal in the market. These tools provide a means to extract fear and greed from the decision making process. Firstly, setting return targets for short term investments is a helpful prerequisite step like selling off after a 15% ROI, for example. In this case, a potential exit strategy might be not selling off until prices fall by 10%, a trailing stop loss order would be effective to prevent panic from forcing the sale of the stock after, say, a 5% decrease. By having that specific exit point, enough room can be made for price fluctuation. Alternatively, the use-case example above for buy stop orders can serve as an effective entry strategy to enter a position.
Missing out on potential gains
One shortcoming of stop loss orders is that they may result in missing out on potentially huge gains. If a sell-stop order is set at the wrong price, an investor may find themselves a victim of short-term market volatility. For example in the case of a company that might be predicted to have a dismal quarter having its short-term future stock decline in price. An investor with a position in this company’s stock could have a sell-stop order set to sell off shares should the price drop below their exit price. Now in this hypothetical instance, the company releases its actual earnings that at the very least meet its initial targets from the previous quarter and at the very most could exceed expectations, in the process dumbfounding nay-saying analysts. Our hypothetical investor would then miss out on the recovery of the stock’s price and a potential rally as confidence is reinstated by onlookers. This is the risk of if a stop loss/trailing stop loss results in an early exit.
Similarly, should a short-term price fluctuation in a bearish market lead investors to think a price trajectory reversal is imminent, a buy stop order could prove especially harmful. Assuming one sees a recent string of higher and higher prices for security, an assumption can be made that the particular security is about to increase in price. Therefore it is possible that a trailing buy stop or buy stop order could be executed at the peak of this apparent price hike. The subsequent reversal to the overall bearish trend could result in great losses for an overconfident investor.
These tools must be used within the context of market stability. A sometimes severe price fluctuation of a volatile market might frustrate the use of trailing stop orders, so it is advisable to tread with caution.
It is worth remembering that with stop-loss orders, in which a fixed price as opposed to a trailing amount, is set, even the fixed price may not necessarily be what the security will sell for should its value drop to that particular point. Market orders are triggered when the stop-loss order is activated and a security’s price falls to a specified price. This means that an ask is made by the investor’s broker to sell at a requested price point. Whether or not this is the actual price the security will sell at is determined primarily by the trade volume at the given time. This determines traders’ willingness to buy at the set price. Many investors instead opt to set stop limits to ensure that a security does not go for lower than a specified price. In this modified form of a stop-loss order, the investor sets a specific stop price that triggers a market order that will sell at a now lower limit price. The limit price is the minimum at which the order will be executed. Say for example in the above-mentioned stock, an investor sets a stop-limit order with a stop price of $92 and a limit price of $90 dollars. This means at $92 a sell order will be placed and only offers above $90 will be considered. Should the value of the stock sharply decline to $80 dollars however, the order will not execute because the current price fo the security is well below the limit order.
Disclaimer
DO NOT BASE ANY INVESTMENT DECISION UPON ANY MATERIALS FOUND ON THIS WEBSITE. We are not registered as a securities broker-dealer or an investment adviser either with the U.S. Securities and Exchange Commission (the “SEC”) or with any state securities regulatory authority. We are neither licensed nor qualified to provide investment advice. We are just a group of students who diligently follow industry trends and current events, then share our own advice, which reflects our personal position in the market.