Provided By David Jenyns & Trading Secrets Revealed

In the previous article, stop losses were discussed as being crucial to prevent excessive losses from building up. In this article, we will discuss a more advanced method of using stop losses not only to protect you from excessive losses but also to help you produce profits on winning trades.

The Trailing Stop Loss

This is a reasonably complicated strategy but is essential to help ensure that your trades are as profitable as possible. A trailing stop is exactly what it sounds like – it is a stop loss that ‘trails’ a trade as it progresses. This means that the current stop loss is reviewed every day and adjusted according to the current market conditions.

Assuming you are ‘long’ in the market, there are two rules you must abide by:

1. A stop loss stays the same or is increased if the stock price increases
2. A stop loss is never decreased in response to a declining stock price – the stop loss will always stay the same in this instance

Types Of Trailing Stop Losses

There are many types of trailing stop losses. Some of the common ones are mentioned below:

• A stop loss that is trailed a certain number of points away from the low of the day
• A stop loss that is trailed a certain percentage away from the low of the day
• A stop loss based trailed on an indicator such as the Average True Range (ATR)

An Example

Let us assume that you bought a stock, XYZ at $10 and have placed a stop loss 10 points away from the low of the day. We now want to trail the stop loss and follow it for a period of 15 days.

• The stop loss will be increased or stay the same if the stock price increases.
• The stop loss will stay the same if the stock price decreases.
• The stop loss will only be increased if the stock price is more than 10 points away. It will be moved to a position that is 10 points away. In other words, if the low of the day is $10.30 and the previous stop loss is at $10.10, then the stop loss will be moved 10 points away to $10.20.

The chart below displays this graphically:

Looking at the chart above, it can be seen that at around days 5-7 the low of the day started to decrease but the stop loss remained the same (as the difference between the low and the stop loss was less than $0.10). A similar thing happened from day 11-15 except that on day 15, the low actually went through the stop loss. The price we would have therefore exited the stock at would be $10.20. This means that we have made a $0.20 profit per share using a trailing stop loss!

The Benefits Of Trailing

There are several benefits of trailing a stop loss.

• The example above shows that from day 3 onwards, the stop loss was $10.00 and above. At this point, the trade could not lose and you would, at worst, come out unscathed. If you had not trailed the stop, you could still lose as your stop loss would still be at $9.90.
• You can lock in profit. In the example above, from day 5 onwards, your stop loss is effectively over $10.00. This means that from this day onwards, you can only win on the trade!

The Disadvantages Of Trailing

• Unless you have a facility that allows a trailing stop to be automated, you will need to review your trade on a daily basis and alter your stop loss accordingly. This means that using a trailing stop can be labour intensive.
• It is possible for you to be stopped out of a trade and then the stock then increases in price further. However, trading is about limiting risk and if you get stopped out of the trade with only a small profit, be grateful for it! There are plenty of other stocks for you to trade.

Summary

On the whole, using a trailing stop loss can be very profitable in the long run. You need to ensure that the method you use to calculate your stop loss works in line with the current market conditions and the particular stock that you are trading.