Trailing Stop Strategy Explained

People talk about timing the market but aren’t they really talking about knowing when to buy or sell?

People talk about timing the market but aren’t they really talking about knowing when to buy or sell?

Newton said it best, what goes up must come down. He didn’t offer any advice about how to react when the thing that went up, in this case an asset’s price, comes down.

When we see the price of an asset going down, we don’t always know what to do. Maybe we should keep it until the price goes back up. Maybe we should cut our losses now.  So we do nothing. All too often, the price continues to go down until it gets to that fearsome place where “it’s too late to sell”. Then not only do we do nothing, we believe we can’t do anything.

Follow the simple path laid out below and you can get yourself out from under the weight of indecision, forever.  You’ll still have plenty of things to worry about but how to handle asset price volatility won’t be one of them. You’ll be miles ahead of most traders because you’ll have a plan. You will know when to get in and when to get out, to ensure maximum returns.

Buying is the easy part. Do your research and plenty of buying opportunities should present themselves. Don’t rely on your barber or hairdresser’s hot tips. Educate yourself about the legitimate theories that guide traders to solid purchases.

Then comes the hard part. You have to figure out when to sell.

Most traders have a story or two (or more) about the ones that got away, not fish – crypto assets! Either they sold too soon and missed the full upside or they held on too long and lost a bundle because they didn’t sell. So what can you do about it?

You need to have an exit strategy that is every bit as informed as the decision you made to purchase the asset in the first place. Pay close attention to the information presented below.

Let the winners keep winning and dump the losers

That may sound harsh but its part of a good, sound trading strategy. There’s no reason to do anything with a rising asset other than watch its’ price rise. As soon as the trend changes from rise to fall, you need to have a clear plan for what to do and when to do it. The goal isn’t to avoid losing any money, ever. That’s impossible. The goal is to keep your overall portfolio moving in the upward direction. 

The Trailing Stop Strategy protects your portfolio in otherwise uncertain times. It’s simple enough for anyone to understand yet sophisticated enough to produce results.

A 25% rule is one example of the trailing stop strategy. Anytime an asset falls by 25%, sell it. Suppose you buy an asset for $100. A 25% Stop would be $75. Now let’s say it goes up to $200. The 25% rule says sell it if it goes down 25% from the $200 high. If you watch it go down to $150, sell – no matter how much you believe in or love the investment.

Losers tend to continue losing

Is 25% better than 24% or 26%? Not really. What matters most is your willingness to execute the trade. Professional traders who just can’t stand watching asset prices go down often use tighter stops. 20%, 15% and 10% are not uncommon. A tight Stop might miss a future move higher. Too loose of a Stop may result in too large a loss. It is up to you to find your risk tolerance.

It’s nearly impossible to recover from a loss of 50% or more. If your $2 stock goes to a $1 price, it needs to double just to get you back where you started. Asset prices rarely rise by 100% in any reasonable time period. The trick is to never allow your loss to get that big in the first place.

The trailing stop strategy can keep you from having to experience those kinds of losses.

Embrace the strategy, question the tactic

The Trailing Stop Strategy is a good practice. Placing stop orders with your broker is not.

If a stock takes a dive, it’s very likely many people who hold the stock have existing stop orders at a similar price. All exchange trades run through licensed members of the exchange. When a bunch of stop order trades come in at the same time, licensed traders tend to hold them. They can choose a time to execute the trade that provides maximum benefit to the licensed trader. That often puts you, the seller, in a less desirable position.

Stocks that have a bad day also have a strong chance of closing higher than the day’s low price. Traders who hold their trade until the exchange opens the next day are often rewarded.

Adopt the strategy and stick to it

If only we had a crystal ball to help us see the future. You may hear claims about market predictions that sound like they come from the absolute most informed and experienced analysts and advisors. Guess what? No matter how many letters these experts have after their names, none of them know what’s going to happen to a stock, an industry or the markets. Why do these pundits brag when they get something right? They’re as surprised as everyone else!

Here are two common sense rules that will serve you well, every time:

1) When you have to choose between small losses and big losses, choose small losses.

2) If your profits want to keep moving upward, don’t stand in their way.

Follow the plan. Trade with discipline and you will enjoy the results.

How big should my trailing stop be?

You need to assess your tolerance for risk, more risk – more potential reward. You should also keep in mind; they don’t call it risk for nothing. You should also have an idea about how long you plan to own the investment. Consider using the 3-to-1, reward-to-risk ratio.

If your research and analysis tells you an investment has 30% growth potential, your trailing stop should be 10%, (30% to 10% = 3 to 1). A position with 75% growth potential would require a trailing stop at 25%. If you expect the investment to grow by 150%, set your trailing stop at 50%.

All you need to break even is for 1/3 of your investments to hit your profit target. This is true even if the other 2/3 decline immediately. In other words, if you pick one winner out of three investments, you break even. But no one invests to break even.

If you do your homework, half of your picks could be winners. The picks you get wrong won’t all decline immediately. Your loss on each investment will be limited to less than 1/3 your expected gains. Your gains could be more than the 3-to-1 you predicted.

Every investor should realize no one picks winners 100% of the time.  This rule doesn’t help improve your ability to pick winners. It just protects you when you don’t.

You can also adjust the rule based on your timeline. Short-term traders will want to go with a smaller trailing stop percentage like 10%. This helps if you’re in the habit of getting in and out of smaller positions, more often. A trailing stop percentage of 25% keeps you in the game longer when an investment declines. It also allows you to enjoy the ride back up if a decline is more severe than 10% or 15%, yet it still precedes a rise in price.

Don’t get stuck on 25%. It’s just a number that seems to pop up in discussions of trailing stop percentages. It allows for normal market fluctuations. It can prevent you from selling too early. Many investors consider 25% a comfortable amount of risk. They sleep better at night being able to answer the question, what’s the worst thing that can happen?