What are Trailing Stops
A trailing stop is an order execution type used for protecting profits. The trailing stop can be entered in terms of percentages or actual dollar amounts for both short and long positions. Trailing stop orders trail the price movements in one direction and as the price moves in your favor, the trailing stop adjusts. This process of calculating the trailing stop is done in real-time. Once the price violates the trailing stop, a market order is sent to close the position. The trailing stop order execution option is not offered by every broker, so you will need to verify if your broker provides this capability.
Example of a Trailing Stop
Trader 1 purchases MSFT on 9/24/07 at $29.13. Trader 1 has a profit target of $29.42, representing a 1% gain. Once Trader 1 achieves his profit target, he places a trailing stop of .3% on his long position, which carries a value of $29.33. MSFT went on to rally to a peak of $29.60 on 9/24/07, without any reactions greater than .3%. From this peak, Trader 1 was stopped out at $29.51 for a gain 1.13%. Now in this example, Trader 1 was only looking for a profit of 1%, but was able to achieve a gain of 1.13%.
Why use Trailing Stops
Trailing stops are good for helping traders when they are unsure of when to get out of a position. It allows you to let your winners run, while keeping a stop order out active to make sure you do not fall victim to greed. The other positive part of trailing stops is that it allows you to manage a number of positions. How many times have you sat in front of your screen micro-managing a position and are unable to look for additional opportunities? Once you have a winning trade and place your trailing stop, you can now focus on finding other positions. This will allow you to carry more positions, thus increasing the amount of positive money you have in float.
How to use Trailing Stops
The first thing you have to do is be honest with yourself in terms of what kind of profit you are looking for in the trade. Only you can determine this number. The profit target is a by-product of the time frame you are trading, risk parameters, and your skill level. Once you have your profit target, you will then have to determine how much you want to trail the stock by. Remember, the tighter your trailing stop, the more likely your stop will be triggered. But, again, this goes back to how comfortable you are with your target level. If you are truly at peace with your target, you will care less if your trailing stop is triggered.