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.
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.
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…