Trailing stops are crucial investment tools. They offer downside protection when stocks drop, and they help secure profits during an upward run.
But in order for trailing stops to work, investors must understand how and when to use them.
Money Morning's Chief Investment Strategist Keith Fitz-Gerald knows all about "risk management" when it comes to money. He's been investing and trading for more than 30 years.
Fitz-Gerald says "it's not that investors don't want to control risk, they're just not sure how and they don't make it a priority."
After all, the key to getting rich is by not losing your money in the first place. And this takes discipline. You've got to know how to make investment strategies work for you.
Here's how trailing stops can help.
First, What Are Trailing Stops?
A regular stop loss is based on the absolute value of a stock's purchase. Its job is to limit an investor's loss on a position should the stock trade below a certain price. If this predetermined price is hit, shares of the falling stock are then sold at the next available price.
A trailing stop, however, adjusts itself to a stock's price change. When a stock price increases, the trailing stop "trails" it upward a predetermined percentage point away from its current market value. Should the share price fall, the trailing stop holds at a predetermined percentage point below its value, preventing further loss.
Here's an example: Let's say you purchased a stock in XYZ for $50 per share and put in place a trailing stop of 15%. At $50 a share, you'd have a $42.50 trailing stop. Should XYZ's stock go up to $60, your trailing stop would rise to $51 (earning you, in this case, $1). If the share price goes up even further to $70, your trailing stop would rise to $59.50.
On the flip side, if XYZ never rises but instead drops as soon as you buy it, your trailing stop has been set for $42.50. That 15% is the maximum loss.
How to Set a Practical Price Point with Trailing Stops
The percentage point that you set for your trailing stop depends on a couple factors: risk tolerance and the volatility of the market. Conservative investors might choose a trailing stop that's about 10% to 15% under the share price. Conversely, more aggressive investors might set their stops at 25% to 35%.
The standard set for Money Morning investors is usually 25%, but there are exceptions. Money Morning's Biotech Investment Strategist Ernie Tremblay recommends 35% when applying to biotech stocks. He says, "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."
And as far as market volatility is concerned, it's important to remember that each market has its own unique volatility - or measured movement known as "the noise." It's important to study a market's noise to determine where and when to enter and exit a trade. This takes patience, discipline, and practice.
Both Ernie Tremblay and Keith Fitz-Gerald have been using trailing stops for years. Fitz-Gerald recently told investors about "Ultimate Trailing Stops" - a tool few use, but one that has a place in every investor's toolkit.