Understanding Trailing Stops

 


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Once you are in the trade and your stock has started moving in your direction, you need to extract as much profit as possible. Not being able to do so will make you a losing trader in the long run.

How can a trader lose if he only takes small profits at a time? Profit is profit, isn’t it? Not exactly… Profit of $100 is not the same as a profit of $250. If such profits are followed by two losses of $75 each, profit of $100 will become $50 loss, while profit of $250 will become $100 win.

Do you get the point?

Profits are always followed by losses and if the profits are small they will not make up for the losses that will eventually and surely follow. However, becoming too greedy can turn a small profit into a loss. This will make you lose money in the long run. The best solution to resolving these conflicts is to use trailing stops.

As the name says, trailing stop follows the stock price that is moving in your direction.

For example, let’s say that we have bought 100 shares of company XYZ at $50 per share. We will automatically put our stop loss at 49.50. The price starts to move upwards and reaches $51. At that point we don’t want in any case to get out of this trade without profit. We will now move our stop loss to $50.50, meaning that if the price turns against us we will hit sell order once the price hits $50.50 in order to make at least some profit from the trade. If the price continues to move in the positive direction we will keep adjusting our stop loss accordingly. If the price hits $51.50 we will move our stop loss to $51.

Once we are more deeply “in the money” we can start using our stop loss more liberally and give the stock price more breathing space. In our example, this means that if the price hits $53, we could put the stop loss at $52. We are able to do this because we have already made a decent profit and can afford more risk. We can also do this when the stock is in a clear upward trend. Small change in the stock’s direction can mean temporary profit taking, which will be followed by movement in our direction.

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