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Explaining the Trailing Stop Limit and a Better Alternative

Here’s a great question from a subscriber to The Sather Research eLetter about trailing stop limit vs. trailing stop loss.

“I really liked your book and it has been a big help to me. 
I do have a question about the 25% trailing stop on close of market:
What is the difference between trailing stop loss and trailing stop limit & which should I use.  I’ve read what I could and I’m still not sure of the difference.”

Use the trailing stop loss.

trailing stop limit

A trailing stop limit is an order you place with your broker. It places a limit on your loss so that you don’t sell too low.

For example, say you have a stock trading at $10 and you put a stop loss at $9 and a stop limit at $8.50. If the stock suddenly crashes to $7, making your sell order at $7, the broker wouldn’t execute the stop loss because it is below your limit of $8.50. So the stop limit protects against fast price declines.

In a stop loss situation, your broker would’ve just sold your stock as soon as it crossed below $9, in this example you would’ve sold at $7.

I prefer the trailing stop over the stop limit because I don’t care to protect against such fast swings. Since I’m doing end of day trailing stops, the presence of these cases are already much more minimized. At the end of the day, a loss is a loss.

If I lose a couple of percentage points more than 25% because I didn’t have a limit, I’m ok with that. It’s much better than the alternative, which is a stock that skips under the limit and keeps crashing. That’s a much worse situation than losing a couple basis points.

Why is a Trailing Stop So Important?

Before you jump into the market, make sure you have this taken care of. You can easily maximize profit and minimize loss with one move. It’s based on a simple concept.

Cut your losses, and let your winners ride.

All investing should be based on this. Far too many people get emotional with their investments. They don’t know how to identify losers. Yet those are the mistakes that cost the most money.

Even investing legends like Warren Buffett aren’t right all of the time. No one can predict the future, and so nobody is right all of the time.

Being wrong is just part of the game.

The investors who succeed over time are the ones who minimize the losers and maximize the winners. Just as many people who hold on to a loser too long, there are just as many who sell too soon. 

I’m sure you’ve heard of them. They got scared, got nervous, wanted to lock in profits. For whatever reason they wanted to sell.

Then the market went higher. Or rebounded. And just kept going, and going, and going. Not only is the investor missing out on all the gains, but he could’ve participated just by doing nothing.

Now he is miserable, and rightly so. Seller’s remorse. Buyer’s remorse. It happens far too often.

But there is a definitive way to solve this problem. It involves cutting your losses and letting your winners ride. Best of all, it’s easy to implement.

All you need to do is set a trailing stop.

A trailing stop works like this. Suppose I have a stock trading at $100. If I set a 25% trailing stop, my trailing stop will be 25% less of $100, or $75. If the stock falls to $75 at any time, I sell.

Simple enough. But there’s more. Let’s say that my stock has risen to $200. The protective trailing stop trails along with it. So as the stock hits $125, $150, and $175, the trailing stop raises. $93.75, $112.50, $131.25. With the stock at $200, the trailing stop is $150.

What this does is completely reduce your downside risk. With any investment, you will lose at most, the trailing stop amount.

trailing stop

If the stock goes up instead of down, you get to ride it all the way up. Once it stops its run up, the trailing stop locks in your profits and protects you from further price decreases.

Most investing beginners aren’t aware that the market goes into a recession every 5- 10 years. It’s not just during times like the Great Depression either.

Market crashes in 1901. 1907. 1929. 1937. 1987. 1989. 2000. 2008.

Recessions in 1899. 1902. 1907. 1910. 1913. 1918. 1920. 1923. 1926. 1929. 1937. 1945. 1949. 1953. 1958. 1960. 1969. 1973. 1980. 1982. 1990. 2001. 2008.

I don’t say this to scare you. But you need to understand the facts.

Stop looking at the economy as black and white. It’s not sick or well. It’s not recession or not.

A recession is part of the economy. The economy will always have a recession. It’s not the president’s fault, Wall Street’s fault, or your fault.

The economy works like the seasons. When it’s winter, you don’t worry that it will always be winter. Why? Because you know that winter will bring spring, which will bring summer, until it’s winter again.

And it’s the exact same with the economy. And the stock market. It goes up, and it goes down. It goes into recessions, and out of recessions. It booms up, then crashes down.

Instead of always second guessing yourself and fearing the next crash, why don’t you just prepare for it? How? Use trailing stops.

A trailing stop will let you ride the market up, and get you out when it falls. It greatly maximizes profit and minimizes loss, without forcing you to think about it.

I recommend a 25% trailing stop for all of your positions.

Of course, it’s a personal decision and it’s totally up to you. The bigger your trailing stop, the more you could lose. But also, the more you could gain.

Be careful that you don’t set too tight of a trailing stop. A trailing stop of 5% or less will probably have you trading in and out of positions every week. That’s not what we are trying to do here.

The point of the trailing stop is to keep you invested long term. Of course, sometimes the market doesn’t agree with this plan. In this case, you sell and buy in somewhere else next month. With a new trailing stop.

I built this website when I was just a beginner myself. This resulted in me being open to all strategies. I’ve looked at every argument objectively, and I believe it has set myself and my readers up for the most success.

Part of this has resulted in my learning of the trailing stop. It’s used mostly in technical analysis, but you’d be astounded at how powerful it can be when combined with fundamentals.

A value based investing strategy, coupled with trailing stops, will be extremely profitable. Add trailing stops to any investing strategy, and you will maximize profits further.

Everyone talks about stock ideas. When to buy, what to buy. It’s easy to talk about getting in. It’s much harder to talk about getting out. Nobody talks about this part. But this part is one of the most important.

You need an exit plan. You need peace of mind. You need maximum profits. You need minimized losses.

A trailing stop gives you all of this.

The Trailing Stop Order Warning

Now, I don’t advocate putting in a trailing stop loss or a trailing stop limit with your broker for several reasons.

Stocks can swing heavily during intraday trading, and you become subject to the whims of day traders. The flash crashes we’ve seen in recent years will probably only increase in frequency, but they only result in temporary swings. You’ll almost always see the stock recover back to normal fairly quickly, and the only people who get burned are the ones who had market orders in with their brokers.

It just doesn’t make sense. Why would I tell the person (my broker) who’s primary focus is to create transaction costs… why would I tell him my exact plan of where I want to be out of the stock.

Considering they receive millions of orders a day, why wouldn’t they manipulate the order of processing buy/sell orders to increase their transaction fee take. I’m not trying to say that they would, but the way that their financial incentives lie run at a crossroads to our financial interests makes me suspicious about sharing information unnecessarily.

Are there downsides to this idea? Sure. Are there cases where I’ll lose out by doing this instead of a trailing stop limit? Of course.

But the majority of the time I know I’ll be right. Simply because stocks have much more volatility during intra-day compared to end of day prices.

Finding Balance: Trailing Stop vs. Buy and Hold

A common critique about using a trailing stop is that it contradicts the idea of buying and holding for the long term. Part of buy and hold means holding through a steep downturn in the market. Here’s another question from a reader that outlines their concern:

Andrew,

First of all – the investment information you share through your web site really resonates with me!  But I struggle with a topic.

I utilize trailing stop loses alerts to minimize my loses and / or lock in gains. This strategies works well but an investor needs to be disciplined and follow through on selling a stock if the alert is triggered.  What happens if the market quickly switched from being bullish  to being bearish. I could receive alerts for all of my investments. Theoretically I should sell, sell, sell. But this is different from the advice to stay in the roll a coaster and ride out the dip in the market.

Your thoughts on the topic would be great appreciated!

Basically, I use the two different strategies in my different portfolios. It has to match the mindset behind the stock pick. So I have a trailing stop portfolio and a own for “forever” portfolio.

With a trailing stop you are still riding the dips as long as you are reinvesting after selling. I reinvest the next month after I sell in the trailing stop portfolio. Also, that portfolio is in a Roth IRA, so I’m not penalized tax wise for selling early.

To recap: The trailing stop is a very important piece of a portfolio. Adding a trailing stop limit adds a condition that keeps you from selling lower than you’d like. But it also leaves the possibility of skipping past your stop point and having the stock continue downwards.

I prefer using a trailing stop over the trailing stop limit because it hardens your floor. However, I advocate not putting the order in with your broker and tracking it yourself in case of a flash crash or other extreme intraday trading situation.

As a big proponent of buy and hold investing, I attempt to get the best of both worlds by splitting my portfolio into a trailing stop portion and “hold forever” portion. Also, by buying new stocks with the capital right after triggering a stop loss, I increase my exposure to riding out dips in the market and still participating in the recovery.