Manage Risk and Build Wealth Using This Simple Strategy
If you are reading this article today, you have gone through situations in your stock investing/trading experience where you let your losses compound only to eat them later or you were sitting on huge gains but didn’t know when to get out. You have been frustrated and have regretted the feeling when you were down 20% on a stock but you did not get out quickly. You got married to the stock you were holding, hoping for a rebound, only to find that the stock dropped even further to 40% or more. You let your emotions affect your judgment and, out of fear, booked those losses by selling at rock-bottom prices.
What if I told you there was a simple yet powerful strategy to capture huge gains and cut your losses when your position goes the other way? All this without letting your emotions cloud your decisions and have more money to invest at attractive prices.
In this article, I will discuss how to achieve this by using trailing stop orders. You will learn what they are and why they are so important in managing risk so that you can protect your gains and minimize your losses as you continue to build wealth for you and your loved ones.
Let's get started.
What is a Trailing Stop?
A trailing stop is a stop price set at a defined percentage below the current stock price.
As the stock price rises, the stop price also rises. If the stock price falls, the stop price does not change. For a short position, the trailing stop is reversed. It is set at a defined percentage above the market price. As the stock price falls, the trailing stop will also fall. If the stock price rises, the stop price would stay the same.
Once you submit a trailing stop order, it remains in force until it’s triggered by a specific change in the inside bid price (for sell orders) or the inside ask price (for buy orders). Once it’s triggered, it becomes a market order that’s submitted for immediate execution.
Once the market order is submitted, it generally will result in an execution, but there’s no guarantee that you’ll get any specific execution price or price range. The resulting execution price may be above, at, or below the trailing stop’s trigger price itself.
How To Use A Trailing Stop Order?
- Let’s say you buy a stock for $10. If you use a 20% trailing stop, you would sell that stock if it ever closed below $8. That’s 20% below $10.
- However, if the stock went up from $10 to $20, you would move your trailing stop up to $16. That’s 20% below the new closing price of $20. If the stock closes below $16, you sell and make a 60% profit.
- The use of a trailing stop is designed to help you avoid pulling your profits out too early or holding onto a losing stock for too long. But, does a one-size-fits-all trailing stop work for all stocks? Not all stocks are equal. Some stocks are highly stable, like Johnson & Johnson (Ticker: JNJ). They don’t need much wiggle room. Other stocks are highly volatile, like Tesla (Ticker: TSLA), and need more room for market moves.
Interesting Fact: Investors often sell their winners too early and hold on to their losers.
Difference Between Stop-Loss Order and Trailing Stop Order
The difference between this and a regular stop-loss order is that the trailing stop price rises as the price of the stock rises, but never goes down. It’s the combination of protection from the downside and exposure to the upside that makes trailing stops so powerful.
“The most important rule of trading is to play great defense, not offense. Every day I assume every position I have is wrong. I know where my stop risk points are going to be.”
— Paul Tudor Jones
Have An Exit Strategy
Even before making the final decision to buy a stock, you must always have an exit strategy in mind (Remember: great defense). This is critical because it can be the difference between holding on to a stock for too long and taking a huge loss or selling a stock and making a large profit.
Creating an exit strategy also protects you from personal blind-spots and behavioral biases. You will not allow fear, greed or misguided loyalty to a stock stand in the way. The exit strategy gives you the freedom to know that it’s the right time to exit a stock or other investment. You don’t need to worry if there is a sudden significant drop in the stock price. You know that you have a financially sound exit strategy in place.
Why Trailing Stop Matters?
A trailing stop can be good for investors who may not have enough discipline to lock-in gains or cut losses. It removes some of the emotion from the trading process and offers some capital protection automatically.
There are some drawbacks to consider. You need to consider your trailing stop percentage or amount very carefully. If you’re investing in a particularly volatile stock, you could find the stop level triggered fairly frequently. Also, excessive trading can quickly turn into “churning,” with fees and commissions eating into your profits.
“Two primary rules to successful speculative trading are: cut your losses short and let your profits run. Most people cannot deal with those two rules.”
— Dr. Van K. Tharp
Trailing stops can provide efficient ways to manage risk. While standard stop orders can either limit losses or preserve profits, trailing stop orders offer you the opportunity to do both with a single setup. Familiarize yourself with the risks, and explore how trailing stop orders can help support your exit strategy.
Stay tuned for my next article where I will discuss a simple and powerful strategy to generate consistent monthly income and build wealth. The beauty of this strategy is that it empowers you to buy a stock at a price you want. You also get paid as soon as you execute your order!
Feel free to leave your comments, suggestions or feedback below. If you would like others to benefit from this article and help spread the word, please do share on your favorite social media platform.
Thank you for your time. Until next time, good trading and canny investing!
The content in the above article is for information and educational purposes only. It is not intended to be investment advice. Please consider the risk involved and your personal financial situation before investing or seek a duly licensed professional for investment advice.
Other Investing Articles By Me
- Fundamental Analysis Using Company’s Income Statement: https://email@example.com/stock-investing-fundamental-analysis-using-companys-income-statement-37b0d80531f1
- Fundamental Analysis Using Company’s Balance Sheet: https://firstname.lastname@example.org/stock-investing-fundamental-analysis-using-companys-balance-sheet-153531d98f8b
- Fundamental Analysis Using Free Cash Flow Statement:https://email@example.com/stock-investing-fundamental-analysis-using-free-cash-flow-statement-454beaa7f00
Amrut is a Full Stack Software Engineer who is passionate about tech and Software Development in Web and Mobile. He likes to write about coding, investing, trading, finance, and economics. In his free time, Amrut likes to understand business models of publicly traded companies and analyze their financial statements. He strongly believes in adding value to people’s lives through quality work and empower people to take control of their personal finances. He also loves to watch and discuss American Football.