Trailing Stops Explained – And Why You Need Them

This simple tool helps you minimize loss and maximize profits. Here's how to put trailing stops to work for you today. 

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Here at Money Morning, we're big proponents of using trailing stops as an easy and effective way to mitigate risk and boost gains.

And yet a surprisingly large group of individual investors don't use them, or have never heard the importance of trailing stops explained.

Perhaps they think using stops is too complicated (it's not). Or maybe putting trailing stops in place is on some nebulous "to-do" list, and it's a task that never gets done.

But consider this to be necessary investment portfolio "maintenance," not unlike the maintenance you must stay on top of for your home or your car. Regular oil changes and gutter cleanings, for example, protect your vehicle and your house respectively from serious and even catastrophic damage.

Likewise, using stops can keep your investment portfolio running smoothly – and protect it from devastating loss.

Stop-loss orders enable you to cut your losses and walk away from a stock before it swallows your savings in its downward spiral.

Trailing stops go a step further – not only do they safeguard against excessive loss, but they also help preserve your profits.

To begin, here is how stop-loss orders work.

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Stop-Loss Orders: Know When to Cut Your Losses

A stop-loss is an order, either formally placed with your broker or a mental reminder, to sell your stock when it declines to a certain price threshold – what you have calculated as the maximum loss you are willing to bear.

Usually, the stop is based on a percentage of your purchase price, but it can also be an absolute dollar amount (a "chandelier stop").

You can easily put stops in place when you buy your stock on your broker's website. If the price of your shares declines to the stop level, it becomes a market order and triggers an automatic sale of your shares.

You can also just set an alert on whatever portfolio-tracking website you use. If the stock reaches that price, you can make an instant decision on whether to cut it loose or keep it (a "mental" stop).

Most investors use stop-losses for one simple reason: If your stock doesn't rise as you had hoped it would, stop-losses limit your potential losses.

Sure, it's true that if you are diligent in using stop-loss orders, you can be "stopped out" of what could end up being a very good stock – if the stock takes a temporary nose-dive. But you can always buy back in.

The actual percentage you set is up to you and depends on your personal risk tolerance. Very conservative investors may want to place their stops at 10% to 15% below their purchase prices. Moderate risk takers might set stop-losses at 15% to 25%. Finally, aggressive investors, who have a longer time frame and don't panic at short-term losses, may set their stops at 25% to 35% of their purchase prices.

In non-volatile markets, a 20% stop is sufficient for most stocks. However, if the company operates in a fairly volatile industry (like biotech or tech), a stop up to 35% may be desired.

Here's how a stop-loss order works:

Let's say you bought Apple Inc. (Nasdaq: AAPL) stock in July 2012 at $613 per share, and you set a 10% stop. You would have been "stopped out" when Apple fell to $551.7 in November 2012 (10% or $61.30 less, in this case, than you paid for it), thereby capping your losses and protecting yourself in case the stock goes into a free-fall.

Chart for Apple Inc. (AAPL)

Source: Finance.Yahoo.com

But in a hearty bull market, if you use a regular stop-loss, you will leave money on the table.

And this is where trailing stops come in…

Join the conversation. Click here to jump to comments…

  1. yngso | November 23, 2013

    Thank you!

  2. H. Craig Bradley | November 23, 2013

    TRAILING STOPS HAVE THEIR LIMITS

    Trailing stops work to a certain extent, but at times with volatile momentum stocks like Apple, not so well. In my experience in 2010-2012 it did not matter exactly where I set my "trailing stop" with Apple, because it always seemed to go just below where my stop was and then soon back up again. During the "Flash Crash" in May 2010 lots of stops and limit orders triggered sells. So, it works on average but in certain markets or particular stocks, it still is a gamble and not exactly easy to pick the right price.

    • David Cross | November 26, 2013

      I heard rumor that TradeStops.com is bringing out a new service soon that might help with this.

  3. ajoseph Tierney | November 25, 2013

    good advice

  4. Owen Stickels | December 13, 2013

    Running a stop loss is as natural an event in my share-trading as strapping into my car. I wouldn't dive headfirst into a river without first checking for submerged logs (paraplegia is not funny); I wouldn't own a home without fire, flood and all-the-rest insurance and I – sure as hell – would not buy a stock without knowing at what level I'd sell it if the price turned downwards. I invest in low-cap mining stocks and run my stop-loss at about 5-8 per cent.

    Works wonders!

    I know too many who haven't a clue about stop-loss technique or, if they do know, are short on the discipline to employ it. Or, worst of all, they've listened to their brokers telling them, "No! No! This drop is just temporary. The stock'll recover." All of them … and I say again … all of them have lost hundreds of thousands of dollars (in one case, seven million).

    If you're the sort of person who lets your kids play chasey on a busy street, walks through long grass with bare legs in high summer in snake country and drives a car when drunk, by all means never use stop-losses in your trading or investing.

    I'll set aside an extra plate for you down at the soup kitchen.

  5. Owen Stickels | December 13, 2013

    A friend has seen my earlier effort and asked me to 'write a little more'.

    So … here are three good things that happen when you embrace the stop-loss mentality:

    1. Quoting Nancy (above) when she mentions the investment portfolio; a stop-loss 'can protect it from devastating loss'. She's right! The people I wrote about earlier who didn't use them were seriously hurt financially. One of them is now out of the game. Provided that your stock's price does not suddenly (and, therefore, catastrophically) plunge down below your stop level – effectively jumping it so that don't get out of it (it happens!) – you will be safely rid of the stock doing what you MUST do to survive, i.e. protecting your capital. That's absolutely what all the top traders say that you should do. It seems to be investors, by the way, who avoid using stop losses because they're in the market '… for the long term'. Tsk! They're the ones who got hurt in '87 and in 2008's GFC. It could be said – in truth – investors are the 'true gamblers'. We traders regard a loss simply as a cost on the way to making profits. And we sell without a second thought, because we know that that first loss is the smallest one we'll have on that stock at that moment. It's a small loss … and it's not devastating.

    2. Following on from #1, it is, in effect, liberating to take a loss because – suddenly – we've got some new money to invest. From my effort above, you know that I use a stop-loss between 5 and 8 per cent, so that – say – $10,000.00 invested would be down a maximum of just $800.00. Too often the problem seems to be that the investor focusses on the, "Oh! No! If I sell, I'm going to lose $800.00." when what they should be doing is looking with renewed vigour on the $9,200.00 they have avaliable to make a new investment. "Whoa, fresh money!" Traders, by the way, are very happy to go to cash at any time.

    3. Quoting Nancy again: "But you can always buy back in." Exactly!!!! Many's the time I've stopped-out of a stock that I like. If I still, for either fundamental or technical reasons (or both), have faith in the stock, I wait for a buy signal and jump right back in. In Jack Schwager's book, 'Stock Market Wizards' (HarperCollins, New York, 2003), champion trader Mark Minervini said, "If a trade doesn't work out quickly, I take a small loss, and I may have to take a small loss many times."

    Minervini's record is based on a five and a half year trading period after he had consolidated his various accounts into one account. His 'average annual compounded return during the period has been a towering 220 per cent' (Schwager, ibid, p 161). He knows what he's doing.

    He said a little earlier in the book, "I have a saying: 'Being wrong is acceptable, but staying wrong is totally unacceptable'. … the key is managing the downside. Good traders manage the downside; they don't worry about the upside." (Schwager, ibid, p 168.)

    Thanks, Nancy. Great article about the single most effective tool investors can employ to (quoting you once again from the very first line you wrote) '… mitigate risk and boost gains'.

    All hail the Stop-Loss!

  6. Will | January 8, 2014

    Of course a stop-loss is a requirement, but unless you are using Level 2 visibility on the markets or even level 3, you are just another sheep to be sheared, as the professionals "gun the stops" to take out the small traders on the way to ever greater profits…

    Ever watched how the index or share you are watching has a big move in two directions up/down or down/up before assuming its daily direction? That's the big money Insti's "gunning the stops" – they have to make their money somehow, and the sheeple are the ones who provide the fleece…

    Mental stops, preferably, but picking the right stock for the right reasons, doing your due diligence, but watching the news flow is now more important in my opinion. The 3 Ms still matter most: Market, Management and Money.
    The Right Market
    The Right Management
    Enough Money to fulfil the management's vision.
    But as Darren Winters has said on many occasions: The economy is 80% of a company's success – in other words – The Fed, BoE, BoJ, ECB, PBoC, and RusBank – or whatever the Russian Central Bank is called and what they do.
    But this money printing extravaganza has to end soon or the end result is hyper-inflation which will be endemic, and when it stops…
    Oh, that party will leave some hangover…

    W.

  7. robin | February 8, 2014

    Will's position is what I follow . Yes, I have lost Lots Of money-real hard earned money. Easy to catalog: 2001-2002 most high flying tech stocks tanked. I had bought Nortel for 4bucks, was 68 I was busy looking for new job when it went bankrupt. My portfolio of 250k all in techs went to 50k in no hurry. Another loss all in banks 2008 Another time 259k we t down to 25k just like that.
    One has to be very vigilant is what I learned. As I approach retiring age, seems some intangible self-protecting mechanism sets in your mind. Maybe that will save me from stupid passivity to action day in day out.

  8. Jim | February 16, 2014

    Did not see the tax implications of using the stop-loss strategy. By selling you are creating a taxable event for the IRS. With a gain, you will of course pay capital gain (whether you eventually buy back into the stock or not). With a loss, you will be out of the stock for 30 days, unless you want to lose the tax benefit of the loss. Right now, it looks like I will pay more to get back into Apple than what the stock was selling at before the January drop (or lose the tax benefit of the loss). I am sure there are other posters who can comment on this aspect.

    In addition, my brokerage house charges for stop-loss orders but does not for regular sell orders. In other words, you would use the mental stop-loss order rather than a computer driven one to avoid the charge. I have also seen stocks that can trigger a stop loss by pennies and go back up. So, there is something to be said for human intervention in using the strategy. As those of you who subscribe to various services of Money Map press, the stop-loss strategy is not always applied.

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