A trailing stop loss works similar to a normal stop loss, but the “stop point” can move depending on the highs or lows of the price since you placed your order.. The only difference being that while we calculated our stop loss from the entry price, we’re calculating our trailing stop loss from the highest price since entry. The key to the trailing stop loss is that it tries to keep the same stop rule you originally used, but also protect any future gains that you make.
The method that you use to set your trailing stop loss can vary dramatically. However, if we use the ATR method that we used to calculate our initial stop to set our trailing stop loss, we’ll have the ability to lock in the profit as the share price increases.
For example, if you bought a share of Sprint ([hq]S[/hq] at $5, and your initial stop was set at $4.90, your trailing stop would also have a value of $0.9 to have the same trigger. If, after the first day, the share price moves in your favour and moves to $5.10, you would recalculate your trailing stop loss by subtracting two times the value of the ATR from the new high price of $5.10. For simplicity, let’s assume that your stop size hasn’t changed, and is still ten cents wide. When you calculate your new trailing stop loss, by subtracting the 10 cents from $1.10, it would be set at $5.
At this point, your initial stop was at $4.90, and your trailing stop loss is now at $5, with the share price is at $5.10. Since your trailing stop loss is higher than your initial stop, the initial stop becomes obsolete, and our trailing stop loss becomes your active exit. Want to try it? [trade]S[/trade]
How much profit have you made on this trade? The share price is at $5.10 and we entered at $5. If you thought, No, I haven’t made any money, then you’d be right on track. Remember, our stop loss strategy gives the share price a little bit of room to move.
You’re not going to exit this position until the share price reverts to $5. It is important to note that when you are valuing any open position, you should always value it based on its stop loss value, since if you were to exit this share, you would wait until that price point was breached.
Let’s go back to the example. Now, what happens if the Sprint’s ([hq]S[/hq]) share price begins to fall? Let’s say that the share price falls from $5.10 down to $5.05. What does your trailing stop loss do? Would it move down also? Here’s another important point. A stop loss will never, ever move down. A trailing stop loss can only move up. This ensures you lock in profit and that you’ll also get out of the shares once they start to turn. A trailing stop loss is always calculated from the highest price since entry, so the highest price is still $5.10.
It’s not until the share price makes a new high since entry that the trailing stop loss would begin to move in your favor again. However, if you’re using the ATR method, there’s another way for our trailing stop to move up. This would occur when the volatility of a stock begins to decrease. If a share price were to begin to move sideways, the ATR value would start to drop off. This would cause the trailing stop to move up as the share price became less volatile.
The best way to understand these concepts is to print out a chart with the ATR values along the bottom. Then on the chart, identify the point where you would have received an entry signal, and mark your initial stop loss and your trailing stop loss.
As the trend progresses make sure that you recalculate the value of your stop so you can begin to get a feel for the way this method of using a stop loss works Seeing how the changes in stock price affect you trailing stop loss will give you the confidence to make them a key part of your trading system.
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