Examining Different Trailing Stop Techniques

Deciding the appropriate time to exit a position is just as important as determining the best time to enter in all forms of long-term investing and short-term trading. Some general techniques can help you identify the optimal moment of exit and ensure acceptable profits while guarding against unacceptable losses.

Your profits stare you in the face when it comes time to exit but you might be tempted to ride the tide a little longer. Maybe your heart tells you to hold tight in the unthinkable case of paper losses and wait until your losses reverse. Such emotional responses are hardly the best means by which to make your selling or buying decisions. Many overarching trading systems have their own techniques to determine the best time to exit a trade.

What Is a Trailing Stop?

Trailing stops are orders to buy or sell securities if they move in directions that an investor considers unfavorable. These orders can be set at a specific percentage or dollar figure away from a security's current market price.

A trader can generally place a trailing stop below the current market price for a long position or place it above the current market price for a short position.

Momentum-Based Trailing Stop

The most basic technique for establishing an appropriate exit point is the trailing stop technique. It simply maintains a stop-loss order at a precise percentage below the market price or above in the case of a short position.

The stop-loss order is adjusted continuously based on fluctuations in the market price, always maintaining the same percentage below or above the price. The trader is then guaranteed to know the exact minimum profit their position will garner. They'll have previously determined this level of profitability based on their predilection toward aggressive or conservative trading.

Deciding what constitutes appropriate profits or acceptable losses is perhaps the most difficult part of establishing a trailing stop system. Setting your trailing stop percentage can be done using a relatively vague approach. This is generally closer to emotion rather than precise precepts. You might wait for certain technical or fundamental criteria to be met before setting your stops.

Effect of Fundamental Analysis

A trader might wait for a breakout of a three- to four-week consolidation and then place stops below the low of that consolidation after entering the position. The technique requires the patience to wait for the first quarter of a move, perhaps 50 bars, before setting your stops. It brings fundamental analysis into the picture by introducing the concept of being overvalued into your trailing stops.

The trailing stops are to be tightened to a smaller percentage when a stock begins to exhibit a price-to-earnings ratio (P/E) that's historically higher and above its forward one- to three-year projected growth rate. The stock's apparent state of being overvalued may indicate a reduced likelihood of additional realized profits.

A Rolling Stop System

The overvalued situation is muddied even further when a stock enters a "blow-off" period in which the overvaluation can become extreme and can last for many weeks, even months. Aggressive traders can continue to ride the train to extreme profits by rolling with a blow-off while still using trailing stops to protect against losses.

Unfortunately, momentum is notoriously immune to technical analysis. The further the trader enters into a rolling stop system, the further removed from a strict system of discipline they become.

The Parabolic Stop and Reverse (SAR)

The momentum-based stop-loss technique is undeniably sexy for its potential for massive ongoing profits. Some traders prefer a more disciplined approach suited for a more orderly market, however. It's the preferred market for the conservative-minded trader.

The parabolic stop and reverse (SAR) technique provides stop-loss levels for both sides of the market, moving incrementally each day with price changes. The SAR is a technical indicator plotted on a price chart that will occasionally intersect with the price due to a reversal or loss of momentum in the security in question. The trade is considered to be stopped out when this intersection occurs. The opportunity exists to take the other side of the market.

You might sell short with a trailing stop immediately set opposite or parabolic to the level at which you stopped out your position on the other side of the market if your long position is stopped out. The security is sold and the position is thereby closed. The SAR technique allows you to capture both sides of the market as the security fluctuates up and down over time.

SAR Considerations

The major proviso of the SAR system relates to its use in an erratically moving security. Your trailing stops will always be triggered too soon before you have an opportunity to achieve sufficient profits if the security fluctuates up and down quickly. Your trading commissions and other costs will overwhelm your profitability, as meager as it might be, in a choppy market.

The second consideration relates to the use of SAR on a security that isn't exhibiting a significant trend. Your stop will never be reached if the trend is too weak and your profits won't be locked in. The SAR is inappropriate for securities that lack trends or whose trends fluctuate back and forth too quickly.

The SAR may be exactly what you're looking for in determining your levels of trailing stops, however, if you're able to identify an opportunity somewhere between these two extremes.

The Bottom Line

Deciding how to determine the exit points of your positions depends on how conservative you are as a trader. You might determine your profitability levels and acceptable losses using a less precise approach if you tend to be aggressive, such as the setting of trailing stops according to fundamental criteria.

The SAR may provide a more definite strategy by giving stop-loss levels for both sides of the market if you like to stay conservative. The reliability of both techniques is affected by market conditions so take care to be aware of this when using these strategies.

Disclosure: Investopedia does not provide investment advice. Investors should consider their risk tolerance and investment objectives before making investment decisions.