A trailing stop is simply a stop loss order that moves up as the stock moves up but doesn’t move down as the stock moves down. For instance a 10% trailing stop on a $100 stock would start off at $90 if the stock moves up to $110 the stop would also come up to $99. But if the stock fell at this point the stop would stay at the same level and get you out if it dropped to $99 or lower, thus limiting your losses while maximizing your gains.
Creating trailing stops has its many advantages.
1. Limits Loss
No matter how good of a trader you are you will eventually have losses. You will need a way to limit them so that they do not affect your overall return that much.
If you decided to place a 10% stop for instance you would be risking only 10% of the investment that you just made. If the stock suddenly pulled back 50% you would get out near the top and could wait for it to turn around before getting back in.
2. It Does Not Limit Gains
The second big advantage of trailing stops is that they do not limit your potential gain. If you decided to buy a stock and then place a 10% stop loss on it you would just be limiting your potential loss, not your potential gain. The stock could go up to infinity if it wants to and you would benefit from it, only once it pulls back 10% would your stop kick in.
3. The Emotions Are Taken Out of Trading
Everybody has emotions. But when you are dealing with money those emotions can affect you in a negative way as they make it harder to think clearly.
Creating your own game plan is important. But it is also important to stick to your plan and not change it every 5 minutes. That is why trailing stops are so powerful because you just set it up and never have to make another decision about the trade again.
A trailing stop will follow the stock up and exit as soon as it turns around. Really the only thing you need to do is to find a strong stock and set up the trailing stop on it.
This way you can have a computer follow your “game plan” because they will likely do it better then you.