Trailing Stops: Using a Ratchet Effect to Advantage

When to use a trailing stop.
A trailing stop could have avoided a lot of antacids associated with owning this stock.

I recently wrote about stop orders. Briefly, they allow an investor to set a threshold that, should the market price for stocks he owns reach that threshold, his stocks will be sold into the market, even if the investor is not watching the markets at that particular moment. This post is about another tool in a similar vein that investors should be aware of. It can be used to ride a stock on its way up, and then to sell that same stock close to its top. At worst, a trailing stop helps you cut your losses. At best, it lets you automate the process of getting out while you’re ahead.

Trailing stops: not the same as stops along the trail

As you can see from the chart at the top of this post, CarfinCo (Car Finance Company) — which I am long at the time of writing — has had its ups and downs over the past five years. In hindsight, it’s fair to say that the stock has done well enough for itself, but the ride up hasn’t exactly been a straight line. If an investor wanted to try to play the game of market timing, this might be a fair candidate, so it will serve as our example. A trailing stop is similar to a stop order, in that it’s a more or less a set-and-forget sell order, but different in that the sell order is a moving target. With a stop order, you have to say exactly what price your sell trigger is. As you can see, a “reasonable” level for a stop order with this stock has changed quite a bit over the past five years. At the beginning of 2010, for example, a reasonable stop order could have been set at, or just below, $2. By the middle of 2010, you would probably wanted to have reset the price to $3 or $3.50. While it doesn’t take a long time to re-set a stop order trigger price, the primary benefit of this kind of order (at least from my point of view) is that it doesn’t need to be monitored. (Well, almost. Trailing stop orders are good for a maximum of 365 days.) A trailing stop order automates the process of re-setting the selling trigger price, and takes emotion out of the equation by setting the sell trigger price as a percentage of the highest closing price since the order was placed. Trailing stops are perhaps best explained if they are broken down and explained in two steps. First, if you bought this stock at any point over the past five years and set your trailing stop at 10%, you would continue to hold the stock until it had gone down 10% from where you bought it, at which point it would be sold. That doesn’t sound great, I know, but that’s the worst that can happen. If it never went down that 10%, you would still own it. If you’ve got that concept, you’re ready for the more detailed (and more helpful) second part of the explanation. Instead of the sell trigger being 10% below your original purchase price, the trigger price would be 10% below the highest that the stock has traded at since you bought it. This price starts at 10% below your actual purchase price, but it climbs as the price of the stock climbs. In other words, the trigger selling price follows the stock up. As long as the stock keeps heading north, you will never sell the stocks, and your trigger price will continue to climb, as well — always 10% below its highest point since you placed the trailing stop order. When the stock takes a break and heads down, you have given instructions to sell when the price gets 10% below that highest price. This way, you lock in all but 10% of the climb as profit. By placing this kind of order, you remove emotion from the decision about if or when to sell, and you avoid giving in to your primal loss aversion fears. Looking at this chart, and using the same 10% mark as an example (in actual fact, you can set it at whatever percentage you want) sell orders would have been triggered at some point in 2011, in early-to-mid 2013, and again in the first part of 2014, assuming you held the stock from some earlier point. Exactly when and if the sell orders would have been triggered depends on the actual purchase price and the magnitude of the trailing stop.

 So is this a guaranteed way to make money?

Really? You’re really going to ask that? No. No, it’s not. It’s still possible to buy at given price, only to watch the stock fall. Assuming you entered a trailing stop order immediately after you bought the stock, the stock would be sold after it had gone down 10%. It’s possible for that to happen again and again. Each time it did it would cost you an additional 10%. In my opinion, the best time to use a trailing stop is after a stock you own has already gone up significantly in price, and you want to be sure that if it goes down, you get most of the price increase. If, for example, an investor bought CFN in mid 2012, or mid 2013, and a trailing stop order had been placed at those times, the investor would have had his stock sold during the rather steep drops of 2013 or 2014, respectively. That investor would have captured most of the run-ups, but gotten out before it fell too far. At that point, the investor could move on to another stock, or wait for this one to bottom out and then repeat the process. All this having been said, I do not make great use of trailing stop orders. When I buy a stock, it is for the long-term dividend, not for a short(er) term capital gain. I used a trailing stop once, about five years ago, just to test-drive the concept, but that was the only time I have used a trailing stop to date. Just so you know, that time, things worked out well. My BMO stock fell, was sold for a profit, and I was able to re-purchase it at a later time, for a lower price. The net effect was that I was able to increase my dividends from BMO. I actually got to have my cake and eat it too. After I had re-bought it, BMO continued to climb higher, and I  sold it for a nice little profit. I am not one to confuse luck with skill, so I have not tried to replicate that experience, as rewarding as it was.   If you’ve already read my article on stop orders, then you’ve come to the end of this post. If you haven’t, read on!   Here are some caveats, condensed from my original article on stop orders. If this is a new concept, be sure to read the full version. a) your stocks will be sold at the market price, which can be below your trigger price b) stocks can “gap down” overnight, making situation a) worse c) you have enter a “limit variance”: a maximum amount below your trigger price, below which your stocks will not be sold If these points are not clear, they are explained in more detail in my stop orders article. Or you could post a question, and I’ll do my best to clarify.

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