If you are learning to invest, then it is important to understand how to use the trailing stop. There is an old rule in the market, often repeated by Jim Cramer on his "Mad Money" program on CNBC:  "Bears win, bulls win, pigs get slaughtered." This means that those who hold on to their stock to long will end up losing money.

So, when you should sell your stock?  Sell strategies are just as important as your buy strategy. It seems everyone has their preferred way to buy a stock. Every investment newsletter lists stocks to buy now; your broker has her favorite "strong buy" list; your friend at work has his "can't miss" stock to buy now; heck, even the taxi driver has their favorite stock idea. Let's assume they are each right with their picks. You followed their recommendations and the stock has gone up. Now what. Do you keep holding, hoping it will continue to go up? Do you sell it all, or maybe sell some of it? 

Well these are all good questions, since you do not make any money until you sell what you bought. To bad none of these people told you when to sell. Up until now any gains you have are unrealized and exist only on paper. Only through the act of selling will you actually realize any profits from your investments and trades. Now, if you only knew what to sell and when to sell it.

Actually there are five reasons to sell your stock that has unrealized gains. For purposes of this article we are only going to focus on selling strategies for stocks that have profits (unrealized gains). Please see Stop Loss Orders if you wish to learn more about how to sell when you are experiencing losses. 

The five reasons to sell a stock that has unrealized gains are:

• The price has reached your predetermined exit target you established when doing your homework before you made your purchase;
• The price drops back down to your trailing stop order that you have set according to your stop rules;
• You need the money for some other purpose (to buy another more promising stock, to invest in some other asset or for some other good reason;
• As a part of good capital management you wish to realize some of the gains and reduce your holdings of this stock; and
• You have reached the end of the time you gave for this stock to perform and you believe there are better opportunities.

The rest of this article will focus on Trailing Stops. Please see Sell Strategies - Setting your Exit Target to learn how to determine the target exit price.

How many of us have held stocks in our portfolios that performed well and then pull back below our purchase price? If only we had a tool that could manage our downside risk so that we get out earlier with potentially greater gains (or minimized losses). All too often we delay selling when our stocks start to show a downturn, in the hopes that the decline is temporary and the price will recover. Trailing Stops can be used as a more disciplined approach to manage our exit strategy.

The trailing stop is an excellent method to lock in profits by placing a stop order below the current price that will execute if the price falls to that level. The goal of a trailing stop is to let your profits run while protecting most of them in the event of a change in the stock's trend. The trailing stop should be far enough away from the current price level to compensate for normal volatility as price moves in a larger trend.

There are three primary ways to set a trailing stop, two of which reset themselves automatically. The three trailing stop methods are:

• a percentage below the current price;
• a fixed number of points below the current price and;
• a specific stop price based on a technical indicator or support level that you adjust as the price of your stock raises.

Trailing Percent

The trailing percent stop trails price movements by a set percentage, but only in the direction of the trend. If the price reverses direction, the stop remains at its previous level and will be activated if the price falls below the trailing percentage. The trigger price is readjusted each time a new high is reached. If the stock’s price begins to fall and reaches your calculated stop price, your order will be triggered as a market order and your stock will be sold for the best available price. If your broker allows you to enter your trailing stop as a stop limit order, then you order will be executed at the limit price, if it continues to trade at this price. Using a limit price with your trailing stop order does not guarantee your order will be executed as there must be a corresponding buy to match your sell order. To be sure you execute your trailing stop, I suggest you do not restrict your order by placing it with a limit.

So how do you figure out what percent to use to act as the trailing number on your stock? Well, like so many things involving the market, it depends. The key factors to consider are your own capacity to handle risk and the volatility of the your stock's price.

Let's first consider your tolerance for risk. Since we are discussing stops for profitable trades, we do not have to worry about losing money, just losing some or all of your unrealized gain. Therefore, the risk tolerance decision you must make is how much of my unrealized gain am I willing to risk. Let's say you are willing to loose half of your unrealized gain before selling. Assume you bought Exxon (XOM) on the last day of June 17, 2005 at the closing price of 53.30. It is now June 23, 2005 and the price of XOM closed at 58.41.  You currently have an unrealized profit of 58.41-53.30=5.11 per share, less any commissions and exchange fees. A nice 9.6% profit, yet to be realized. Assuming you are willing to risk half of your unrealized profits, you decide to set your current percent stop at half of the 9.6% gain you now have or 9.6/2=4.8%. This is equivalent to $2.80 per share at a 58.41 share price, meaning your stop will trigger at 55.61. Keep in mind this trigger price will rise with each new high that is achieved. On September 22, 2005 XOM achieved a high of 65.28. Assuming you kept the same percentage, your new stop price would be 62.15 (65.28x(1-.048))=62.15. On October 3, 2005 your stop would have been triggered for a very nice profit of $8.85 per share or 16.6% in 3 1/2 months time.

Hopefully, with this example you now have a better idea how to use your risk tolerance to set your percentage stop. Of course, the percent you are willing to risk changes the stop percent accordingly. Selecting your risk percent is a personal matter that you need to set based on your personality, financial situation and appetite for risk.

Another way to set the trailing stop percentage is using the daily average volatility of the stock. To determine the average volatility compute the average daily high-low price range for the prior month, multiply by 2, and then divide the result by the current low price. This will give you the percentage stop based on volatility. Again let's use Exxon Mobil, this time for the month of July 2005.

The difference column is the intraday high minus the low.  The average of the differences for the month is 1.15. Based on testing by Thomas Bulkowski, 2 seems to be the best multiplier to keep from being stopped out to early. Multiply the average difference of 1.15 by 2 to get the volatility, or 2.30. Converting this number to a percent gives us 2.3/58.75=3.9%, using the low from the last day of the month which is 58.75. This places your stop at 56.45. Keep in mind that this stop will rise with each new high achieved by Exxon just as before. On September 22, 2005 XOM achieved a high of 65.28.  Assuming you kept the same percentage, your new stop price would be 62.72 (65.28x(1-.039))=62.75. On October 3, 2005 your stop would have been triggered for a very nice profit of $9.42 per share of 17.7% in 3 1/2 months time. You can recalculate the average volatility difference each month, however, unless there is a definite change in the volatility of the stock it usually is not necessary.

Now all you have to do is decide which percentage stop to use, while keeping in mind that your choice of the percent you are willing to risk will greatly impact the risk tolerance percentage option. For your information, I prefer the volatility percentage as it provides a more logical stop when I use a percentage stop.  By the way, many online brokers allow you to set the stop based on a percentage.

Trailing Points

Another way to set your trailing stop is to use trailing points. This method is very similar to the trailing percent method, only you use a set number of points below the high price, instead of a percentage. If the price reverses direction, the stop remains at its previous level and will be activated if the price falls by more than the trailing points. The trigger price is readjusted each time a new high is reached. If the stock’s price begins to fall and reaches your calculated stop price, your order will be triggered as a market order and your stock will be sold for the best available price. If your broker allows you to enter your trailing stop as a stop limit order, then you order will be executed at the limit price, if it continues to trade at this price. Using a limit price with your trailing stop order does not guarantee your order will be executed as there must be a corresponding buy to match your sell order. To be sure you execute your trailing stop, I suggest you do not restrict order by placing it with a limit.

So how do you determine the number of points to set for your trailing price? Actually, it is just like using a trailing percent, except you use number of points. Again the key factors to consider are your risk tolerance and the volatility you can handle. Review once again the paragraphs on Trailing Percent to see how to determine your trailing points. The only difference between trailing percent and trailing points is in place of using a percentage to trail your stop you are using the number of points.

The only difference in Trailing Points vs. Trailing Percent is the trailing percent is proportional, so there will be a slight variance in the absolute stop.  Other than that, there is no difference in the use of the two methods.

Specific Price

The third way to set a trailing stop is to use a specific price. This technique takes advantage of the market psychology that is imbedded in the price and volume of a stock. Technicians call these levels support and resistance.  Support is the level which a stock seems to find more buyers than sellers and as a result usually has difficulty going lower. Support levels are where buying overcomes the selling that is causing the price to fall. Resistance is the level where a stock seems to find more sellers than buyers and usually has difficulty going higher. Often these areas are where the stock price has stopped going down and started going up again. The chart of Microsoft (MSFT) is an example of using support and resistance levels to set trailing stop levels.

As indicated in the above chart both support and resistance levels can be used to set your trailing stop. Being an astute investor who uses this site, you bought MSFT when it broke out on 11/23/1998 at 25. Over the next two months it rose to more than 32.5 and then fell back to about 30 before rising again. Looking at the chart you notice that there seems to be some support at 30, especially when you look at the buying volume as the price tested 30 and then moved sharply up to 37.5 by the end of January 1999. Using 30 as your support you decided to set your new trailing stop at 29.93. I like to set my stops just below support and with an odd number to help keep the market makers from taking me out on any dip to support. In February and early March the price of MSFT falls to slightly below 32.5 and then seems to make its next move up from there building a small base at 32.5. You, being an astute investor, decide to move your trailing stop up to just below 32.5, let's say 31.83, to give it some room below support at 32.5. Setting the stop at 31.83 is fairly arbitrary. You want to balance not being taken out by a brief dip with selling on any meaningful reversal in the price trend. Then MSFT makes a nice move to 42 as its next high before pulling back to about 33, where it consolidates for a month and a half.  The next move takes the price up above 42.5 briefly. As a result you move your trailing stop up to just under the latest support level at 33, selecting 32.83. Anyway, this move up and then down to form new support levels continues through November 1999. Being a good investor you move your trailing stop 2 more times, first to just under 35.5 and then again to just under 36.5. You have now locked in 16.5 points of profit per share or 66% in a year's time. A very nice return. Then in December 1999 MSFT makes a dramatic move up to above 50. These sharp moves up often are indications of a final buying spree by investors late to the game seeking to be part of a great investment. Most times they are late to the game.  Anyway you observe that MSFT encountered substantial resistance at 42.5 before it broke through in dramatic fashion.  Resistance, once broken through becomes support. Therefore, you decide to move your trailing stop up to just below 42.5.  Since MSFT made such a sharp move up, likely due to the more naive investors trying to get in late, you decide that you want to keep your stop close to this support level, choosing 42.43. On January 31, 2000, your stop is executed resulting in 17.43 points per share or a very nice 70% gain in 14 months. While MSFT did go back up to 50 briefly it then quickly plunged to 30 in May 2000, probably trapping all those investors late to the party with substantial losses.

Hopefully, this example gives you some idea how to use support and resistance to set your trailing stops. It is important to monitor your stock's chart on a regular basis to assess if you need to adjust your stop. Also, I used support and resistance levels in this example, as they indicate the psychological levels that buyers and sellers tend to use. Technicians also use trend lines, various technical indicators, and moving averages, especially 50 day and 200 day moving averages. Notice on the chart that the selling volume of MSFT jumped when it penetrated the 200 day moving average in early November 1999.  Looks like a lot of people were using this moving average as their trailing stop.

Conclusion

So which trailing stop should you use? I am unaware of any study that statistically proves one is better than the other.  Successful investors and traders use each method. I like to use both the Percent Volatility and the Specific Price based on support and resistance levels. These two methods have some basis in behavioral psychology of the market. I examine the stop each method identifies and then choose the one that seems to fit the current situation the best. I also use what I know about the overall market trends and cycles, the strength of the trend in place and the general economy to help set my stop.

One final issue to consider in setting your stops is whether to use a "mental stop" or actually set up your stops with your broker. At times market makers, the professionals responsible for completing each trade, may push the price down to below support levels to force stops to execute. They do this to get shares to sell when the price goes higher. Of course they are not supposed to do this, but it does seem to happen fairly often. There are two ways to overcome this problem. The first way is to set your stop sufficiently below the support level that you stop will not be part of this action. The other way is to use these stops as mental reminders for you to sell your shares. This requires discipline on your part to execute your trade and not hang on to your shares as the price keeps going lower.  he choice is up to you.

Trailing stops are one of the most important tools you can use in your investing and trading. Be sure to use them either setting them up with your broker or if you believe you have the discipline then use them as mental stops.