What is a Trailing Stop Loss Order?
A trailing stop-loss order sounds like complex investing strategies, however, it is fairly simple to understand when you take a minute to learn what each part of it means. To do that, we’ll go through the different types of orders.
Why learn how to execute these types of trades? For starters, we’re still in a highly volatile market. The S&P 500 is up 67% from its March, 2009 lows (which were down 56% from October 2007 highs). Had you placed a 10% trailing stop loss order an S&P 500 index ETF (i.e. SPY) shares you owned before the market collapse, you would have only lost 10% of your investment off of the peak, versus 56% (like most of us). The same could be said if you bought near the bottom. You’d want to protect your 67% gains, right? Before getting into how to do that with a trailing stop loss order, let’s take a look at some of the basics, first.
Most novice investors will never venture beyond a market order. A market order is an order to buy or sell a stock immediately at the best market price. This differs from a limit order (we’ll discuss in a bit) in that you are not able to specify the price in which you would like to buy or sell at with a market order. There are two types of market orders:
- Buy market order: your trade executes at the real time ‘ask’ price.
- Sell market order: your trade executes at the real time ‘bid’ price.
A limit order is an order to buy or sell a number of shares at a specified price. With limit orders you are guaranteed that the price your order fills at will be at or better than the set price you specified. The problem with this type of order is that if the market price never hits your specified price, your order won’t execute. Here are the two kinds of limit orders:
- Buy limit order: your trade is executed if the market price reaches your specified limit or goes lower.
- Sell limit order: your trade is executed if the market price reaches your specified limit or goes higher.
You basically use limit orders in anticipation of a future event, particularly if you aren’t willing to buy a share for more than a certain price, or sell for less than a certain price.
Limit orders are effective in preventing losses from a wide bid-ask spread.
That brings us to stop orders. These are very similar to limit orders, with a slight difference. A stop order is an order to buy or sell a stock at the market value once a price hits your specified amount. The key part here is ‘at the market value’. Whereas a limit order executes at or better than your specified price, a stop order executes at the market value when your price is hit.
Stop Limit Order
Confused yet? Don’t be. Stop limit orders combine the features of a stop order and a limit order. Instead of relying on market bid/ask prices once your stop order price has been hit, your stop order turns into a limit order and executes at or better than the price you set if another party is willing to fill it.
Trailing Stop Order
Payday. Finally. When you place a trailing stop order, you enter a stop parameter that creates a moving or trailing activation price. This parameter is entered as a percentage change or actual specific amount of rise (or fall) in the security price. Trailing stop buy orders are used to maximize profit when a stock’s price is falling and limit losses when it is rising. Trailing stop sell orders are used to maximize and protect profit as a stock’s price rises and limit losses when its price falls.
Trailing Stop Loss Order
A trailing stop-loss order limits the downside. How would this work in a bull market? Well, let’s go back to the SPY example. Let’s say you put a trailing stop-loss order on SPY of $10. SPY is now at $115. For example, let’s say that SPY falls to $107. No trade would have executed because SPY didn’t lose $10. SPY then goes up to $150. SPY’s stop price would have reset to $140. Then it tanked and dropped to $115 again. Your order would have executed at $140, protecting $25 of your gain. Nifty.
Other Trading Considerations
Keep in mind that using these types of trading strategies frequently can result in added trading fees. It’s for that reason that you should use a discount broker and try to limit the number of trades that you make. My personal favorites is Ally Invest. Also, this is not a recommendation, but rather informational – invest at your own risk.
Stock Trade Discussion:
- What type of stock trades have you used before?
- Have you ever used a trailing stop loss order? How did it work for you?
GE, this kind of investing basic stuff is great. I had no idea anything other than a basic market order was available. This is an easy way to add a little bit of strategy to what is otherwise a guessing game of when to sell.
This article would have saved us some research time a few years ago…
Anyway, thanks for the definitions!
Computing for the optimal “cushion” to allow room for minor correction is the trickier part in using trailing stops.
This is more of a short-term protection strategy, correct? As I understand it, orders usually expire in the (very) near term, otherwise other valid protective instruments such as a longer-term put option would have no audience.
How do I go about setting up trailing stop loss orders for my accounts?