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September 27, 2012

Stop Loss or Trailing Stop?

Some may hear the terms trailing stop loss and stop loss order and wonder exactly what these are and how a stop loss can enhance a trading strategy. Well, fret no more – that is what we will discuss in this blog entry. To get more educational ideas like this,

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sign up for a free two-week trial of Market Taker Mentoring’s options newsletter. Let’s start with the basics, defining a stop loss order. Basically, a trader will tell the broker a certain price on a stock (or option) where the position will be closed; but it’s a little different than a typical closing order. For longs, the closing price is below the current market price and for shorts the stop loss closing order is above the current market. Let’s take a look.

Stop Loss Example
A trader could purchase a stock for $15.00 and set a stop-loss order at $13.50. This means that the position will be closed at the market price once the stock drops below $13.50, simple right? It is called a stop loss order because it rather simply stops the investor from taking any more losses. Many investors have a set percentage of a trade for a stop loss order. If a trader wants to use a stop loss order for an option, the bid and ask prices would be monitored and then the same decisions as were made in the stock example are made.

Trailing Stop Loss Example
A trader chooses a lower target price to keep losses in check and tells the broker to sell the contract once this price is breached. There is another stop loss strategy, the trailing stop loss. A trailing stop loss is either a fixed percentage or a fixed nominal increment from the current market price. Once the market price moves away from the stop, the stop moves, or trails, the market. It remains in place, though, if the market moves towards it.

Once the trailing stop loss is triggered the stock is sold, just like the regular stop loss. The benefit of the trailing stop loss is that it is flexible. If you purchase an option for $10 and set a trailing stop of 50 cents, the sell target is $9.50. Of course, as the stock increases in value, the 50-cent trailing stop will do follow (the stock trades at $10.50, the trailing stop becomes $10.00).

A trailing stop loss, then, can be used very effectively in profit taking. And it may sometimes require an adjustment. Let’s revisit the $10 stock with a 50-cent stop loss. If the company reports blow-out earnings, driving the price sharply higher, it might be time to adjust the trailing stop loss. In this example, let’s say the stock jumped to $12.00. A nice profit, but there could be some more room to the upside. Maybe the trader will adjust that trailing stop a little tighter to, say, 25 cents. Doing so allows the trader to lock in a profit of at least 1.75 (12 minus 10 = 2, 2 minus 0.25 = 1.75).

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

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