Trailing Stop Loss tips
A trailing stop loss works in the same way as a normal stop loss, but the “stop point” can move depending on the peaks or troughs of the price since you placed your order. The only difference is that while we calculated our stop loss from the entry price, we calculate our trailing stop loss from the highest price since entry. The key to the trailing stop loss is that it tries to maintain the same stop rule that you originally used, but also protect any future profits 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 will have the opportunity to lock in the profit as the share price rises. For example, if you bought a share of Sprint for $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 stock price moves in your favor and moves to $5.10, you would recalculate your trailing stop-loss by subtracting twice the value of the ATR from the new high price of $5.10 For simplicity’s sake, let’s assume your stop size has not changed and is still ten cents wide. At this point, your initial stop was at $4.90, and your trailing stop loss is now at $5, with the stock price 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. How much profit have you made on this trade? The stock price is $5.10 and we entered at $5. If you were thinking: No, I haven’t made any money, then you are on the right track. Remember, our stop loss strategy gives the stock price some room to move. You will not exit this position until the stock price returns to $5. It is important to note that when valuing an open position, you should always value it based on its stop loss value, because if you were to exit this stock, you would wait until that price point was breached. Let’s go back to the example. Now, what happens if Sprint’s stock price starts to fall? Let’s say the stock price falls from $5.10 down to $5.05. What does your trailing stop loss do? Would it also move down? Here is another important point. A stop loss will never, ever move down. A trailing stop loss can only go up. This ensures that you lock in profits and that you also get out of the stocks when they start to reverse. 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 stock price reaches a new peak since entry that the trailing stop loss would start moving in your favor again. However, if you use the ATR method, there is another way for our trailing stop to move up. This would occur when the volatility of a stock starts to decrease. If a stock price were to start moving sideways, the ATR value would start to drop. This would cause the trailing stop to move upwards as the stock price became less volatile.
The best way to understand these concepts is to print out a chart with the ATR values at the bottom. Then identify on the chart the point where you would have received an entry signal and mark your first stop loss and your subsequent stop loss. As the trend progresses make sure you recalculate the value of your stop so you can start to get a feel for how this method of using a stop loss works. Seeing how the changes in the stock price affect you trailing stop loss gives you the confidence to make them an important part of your trading system.
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