As I mentioned in my 2014 financial goals post, I believe that the market correction will happen and want to protect my profits for my stock holdings. I have been monitoring the stock market regularly, but was looking for a more automated to do this. Trailing stop loss order and trailing stop limit order are my answers. I came across it by accident as I was setting up manual stop loss order on Fidelity.com. After investing in stocks for 15+ years, I’m just learning about it. I thought it was super useful and wanted to share.
What is trailing stop loss order?
In short, trailing stop loss order and trailing stop limit are ways to set a floor for the stocks/ETFs you hold, if the stock price drops below the floor, it would trigger the sell order to activate. Then depends on whether you have setup a stop loss order or stop limit order, it’ll execute accordingly. The beauty of this approach vs. a regular stop loss order is that the floor moves up as the stock price rises and set a high watermark. If the stock price drops, the floor stays at the high water mark and does not move down, therefore protecting your gains.
Why is it useful?
Let’s take a look at why it’s useful. I think there three main benefits. Mark’s market blog had this very useful graph to illustrate the point. I will walk through the graph as a example to illustrate the benefits.
When I purchase a stock, by setting up a trailing stop loss order with either $ amount of %, this allows me cap my loss or the downside.
Let’s go through the example illustrated in the graph above. Mike purchased stock at $40, he create a trailing stop loss order with $4 below the purchase price, which is $36. If the stock dips below $36, it would trigger a stock sale, limiting his loss to be around $4 per share.
Instead of using $ amount, Mike can also use %, say 10% below purchase price. I personally like %, because I can set the fixed % across all my stock holding without worrying about the stock price.
Continue with the previous example, Mike’s stock did well and rose to $53. The trailing stop loss floor would rise along to $4 below the new current price to $49, which is $9 above the his purchase price of $40. If now the stock drops to $50, nothing happens, Mike will continue to hold the stock. The floor is still at $49, it doesn’t change when the stock price drops from its high. Now, the stock drops further to $49, it would trigger the stop loss order and sell it at market price of around $49. If he had set it as a trailing stop limit order, it would trigger a stop limit order to activate. This would ensure he still have a profit of $9 per share, or 20% gain for his investment. For simplicity, I didn’t take into account of the transaction fee which is small nowadays.
For me, the big value on trailing stop loss order is peace of mind so I don’t have to worry about monitoring the market so regularly. For those of you who have followed my blog for a while, I’m a big proponent of streamlining and automation (for example, streamline paying bills).
By setting a trailing stop loss order for my stock and ETF holdings, I know if there is a sharp drop in the market, I know i won’t lose too much of my gains.
Limitations to trailing stop loss order
Doesn’t work for mutual funds
The biggest gap I see for trailing stop loss order is that it works for stocks and ETFs, however it doesn’t work for mutual fund. I have a fair amount of index funds which can’t be protected by this method. This may force to switch my mutual fund holdings to ETF. As I hold mostly index funds, it’s available through both mutual fund and ETF. One draw back with switching to ETF I can foresee is that I need another way to do monthly automatic investment. Currently, I make monthly contribution to my mutual funds, and there is no transaction fee. For ETF, it would be considered new purchases, and I would have to pay additional transaction for each ETF I invest into. I don’t have a good solution for this yet.
Set the floor carefully
Don’t set the floor too low, as the market fluctuates throughout the day. 3-5% in my opinion, would be too low if you don’t want to deal with lots of buys and sells, and not to mention tax implication.
Don’t set the floor too high either, 20% in my opinion would be too high as it would mean you may loss up to 20% of your investment before the sale would kick in. Somewhere between 8-12% is reasonable depending on your own risk tolerance and volatility of your stock.
I can’t believe I only just learned about this method after all the years of stock investing, but hey better late than never. Now I can sleep a little easier at night.