Stock Trading Tutorial: Stops and Trailing Stops

One of the most common questions I hear about order types is concerning the usage of trailing stops.  This stock trading tutorial will explain how this order type is used and why it is a good technique to have in your trading repertoire.  You will most likely use limit orders and stop loss orders more often, but having another tool at your disposal is always a good thing.

A trailing stop is based off a stop order (stop loss order).  A stop order is an order that will execute if a price of a stock falls to a certain level.  The name stop loss is pretty accurate.  These orders are used to maximize your potential risk on a given trade.  I’ll give an example of a stop order in action.

Let’s say you purchase 100 shares of stock in some company for $14.50 per share .  You want to make sure you don’t lose more than $50 on the trade.  You would set a stop order at $14.  If the stock price rose steadily up to $16 nothing executes in your stock trading account.  If the stock then drops sharply down to $13, you would sell very close to $14 per share (stop orders are executed as market orders so you will sell as soon as possible as the stock price hits $14.. in vary volatile conditions you may sell for $13.98 or a little bit lower).

In this stock tutorial’s example you would have lost $100 on the trade even though the stock went up after you bought it.  Trailing stops can be used to lock in profits.  If you had placed a trailing stop in set up for $50 in that example, the results would differ.  As the stock price rises your stop order changes dynamically.  So as the stock moves up from $14.50 to $15 your stop order will go up from $14 to $14.50.  At this point you are guaranteed a break even trade (except for commissions).  When the stock climbs to $16 your stop order follows, or trails, up to $15.50.  So when our stock in the example drops sharply from it’s peak, your stop order will execute at $15.50 leaving you with a $100 profit.

As you can see from the example, there are many cases where a trailing stop could be preferable to a standard stop order.  The biggest drawback of this type of order is the possibility of exiting your position in a stock prematurely, especially in turbulent markets.  It is hard to gauge exactly how big of a cushion to give your trailing stop in order to protect your potential loss as well as leave room for a little volatility.  Experiment with a demo account to get a good feel for how this order type can be applied to the stock trades you make.

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