Why Trailing Stops Are One of the Most Important Investment Tools Ever

Today I want to offer a deeper explanation of one of the very best investment tools: trailing stops.

Every single one of Money Morning's experts advocates using them, and for good reason.

A "trailing stop" serves a dual role as both a risk-management and loss-minimization device. It allows investors to accomplish two things at once - capture profits and protect capital from catastrophic loss.

Here's exactly how this investment tool works...

How to Use Trailing Stops

A stop loss order is an order placed with a broker or online trading site to sell a stock at a given price. There are two basic types of stop limits you can put in place: a hard stop or a trailing stop.

A hard stop is usually expressed as a dollar amount. So if you buy a stock at $10 and set a hard stop at $8, your stocks will automatically sell if the share price for your stock falls below Investment Toolsthat amount. In this case, you've limited your loss ($2) to 20% of your original position in the stock.

In contrast, trailing stops are typically expressed as a percentage of purchase price. For example, if you buy stock XYZ at $10 a share, a 35% trailing stop calculates to $6.50. If the stock drops to $6.50, the order would execute and carry you out of the trade automatically.

But here's where "trailing" comes in...

With a trailing stop, the exit price increases in lockstep with the market price. That means the "stop" price - the price at which the stock will be sold - is adjusted as the price fluctuates, so if the stock runs up, the trigger price moves up, too. For example, if XYZ climbs and closes for the day at $15, your stop also increases to $9.75 (35% of $15 = $9.75). If it continues to rise to, say, $20, the stop would again automatically stop up, this time to $13 - thereby locking in a profit of at least $3 if the price took a tumble from there. (In fact, it's best to adjust your stop more frequently than that.)

And that's just one reason to use this investment tool...

One Investment Tool, Multiple Benefits

Here's why I like trailing stops so much:

  • They keep you from selling your stocks during powerful uptrends, thereby keeping you invested for maximum profits;
  • They minimize risk by preventing small losses from becoming catastrophic losses; and
  • They keep emotion out of your investing decisions by setting a pre-determined level at which to sell.

It's important to determine what percentage to set your trailing stops to make the most of an investment opportunity. Here's what I recommend...

The Best Strategy for Trailing Stops

Usually the standard we set at Money Morning is 25%, but I like to use 35% for the stocks I recommend.

That's because the bioscience market tends to be more volatile than most. This lets us ride the ups and downs with more confidence that our stocks won't stop out because of temporary price fluctuations.

That said, we will tinker with this number from time to time. If we have a calendar date coming up, I may recommend tightening up the trailing stop - say to 20% - to protect the profits we made during the run-up (the price rise that often occurs as a stock nears a catalyst date). Or if there's downdraft in the broader market, I may suggest widening or even removing your trailing stops on these quality positions. This flexibility will help you achieve maximum profits while still keeping risk to a minimum.

A longtime bioscience investing expert, editor Ernie Tremblay has a proven ability to pinpoint the exact calendar date the pharmaceutical company behind a new therapy can skyrocket in value. These stocks often pop by double and triple digits overnight, then run up to even bigger gains in the months ahead. You can check out his trading service BioScience Millionaire for free here. And you can check out his latest article, "The Secret to Making Money from Bioscience's 'Scariest Event,'" here...

About the Author

Ernie Tremblay has more than 25 years of experience in following and analyzing the latest developments in health, medicine, and related technologies. He understands the FDA approval process, as well as the "hard science" behind new, experimental drugs and the market demand for them - and has a comprehensive grasp of the complex dynamics that determine whether a new drug will be a breakthrough winner, or just another casualty of the FDA approval process.

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