Short answer, I don’t think so … in fact, a trailing stop has nothing to do with increasing returns, it’s all about attempting to limit losses.
But, that was the premise of an article by Debt Free, excerpted here:
A trailing stop limit is simply a stop loss order, but one with a very important difference compared to a traditional stop loss order. A traditional stop loss order is a command to your broker to sell a stock holding when it drops below a preset price.
For example, say you hold 1,000 shares of Microsoft (MSFT) corp that you bought at $10.00 a share. You can tell your broker to sell those shares if the stock ever drops below a price that you feel comfortable with, for example $7.50. That way you limit any potential losses on your position.
There is a problem with a traditional stop loss order however, and I’m sure you’ve spotted it already. What happens if Microsoft corp shows impressive gains for a year, say it increases its share price to $18.00? That’s great, but your stop loss order is still set at $7.50, so if MSFT corp’s stock then drops back down you’ve protected yourself against a 25% loss in your original position, but you haven’t protected your gains at all.
A trailing stop limit changes that for you. A trailing stop limit order actually changes the number at which it goes into effect as the stock price changes. That buys you a very important benefit as an investor. It protects you against loss, but also allows you to make a nice profit while doing so. Basically it mitigates a certain measure of risk while maximizing your investment returns. Anything that mitigates investment risk while allowing an investor to generate potentially explosive returns is a great thing.
Using a trailing stop limit can generate explosive gains for your portfolio because you will maximize gains in your stocks, while minimizing losses. Any time you can do that, you’ll be retired on a beach in Maui that much sooner.
I’ve taken a whole chunk out of the article because Debt Free summarizes the idea of a Trailing Stop Loss quite nicely …
… in fact, whenever I buy a stock I always set a Trailing Stop at about 5%, 8% or 10% depending on the stock and how volatile I think it might be.
Perhaps counterintuitively, the more volatile the stock the higher the number that I set, as I don’t want to be shunted out of a stock that is just bobbing around in a range … the less volatile the lower, usually 8% but maybe 5%, as any downward swing could be a bad sign.
But, I don’t see how a Trailing Stop on its own can generate anything?!
It may help protect you from losses, therefore, may make you overall returns higher (same gains, fewer losses = higher average returns) …
… equally, it can bump you out of a stock that was having a slight correction, but then jumps back up too quickly for you to (sensibly) buy back in again, meaning that you miss out on the upside (lower gains, fewer losses = lower average returns).
In other words, it sure ain’t no Magic Bullet!
And, there’s one other problem with Stop Losses of any kind: they can’t always protect you.
If the stock has a sudden and major drop, the price may suddenly drop from, say, $168 to say $10 (remember Bear Stearns?) … the Stop Loss may trigger the sale (if you have it set to accept the market price) but you will still ‘drop’ 95% of the value of your investment!
The only way to protect against that is to buy a PUT Option (at, say, 8% less than the current price to avoid paying top dollar for the PUT) … that way, no matter how low the stock drops you have already locked in a buyer at the price that you set for the PUT.
So, Stop Losses – particularly Trailing Stop Losses – are a great tool …
… but, using a Trailing Stop Limit can’t generate explosive investment returns on it’s own … only time and/or luck can do that!
I agree that a PUT option will hedge against potential losses but they can be expensive for volatile stocks. Would you recommend financing the PUT option by selling the CALL option and hence creating a collar or synthetic call spread?
@ Mark – I presume that you are talking about a ‘covered call’ which means that you own the underlying stock? In which case, you have a ‘super low risk’ strategy with only one problem: the cost of the PUT may negate the profit on the Call! You need to price carefully … probably not a good strategy in anything but a sideways market.
I don’t like stop loss orders for several reasons:
They insure a loss as well as the taxes and commissions of a sale if the stock is just a bit more volatile than I though… Also, a stop loss may get you a worse price- say when the market overreacts to bad news. How often have you seen a stock tank when earnings are a few cents shy of estimates then recover in a relatively short time?
A change in stock price is not necessarily a good indication of a change in a company’s true value/likely future value. If I pick a stock for a good reason and my reason doesn’t change I should celebrate that the price has gone down and BUY MORE not sell!
I think alerts make more sense- if a stock is dropping you should re-evaluate it and then if it makes sense sell… or buy!
@ Rick – Yes; if you are committed to “buy and hold” then you should look at a dip as an opportunity to buy more of a good thing ‘on sale’ … if you are SURE you are on a good thing and not staring at the next Bear Stearns 😉 If you are not sure: (a) don’t buy, (b) if you must buy use a trailing stop or (c) for ultimate (expensive) security against dips buy a PUT.
I’m not a day trader- with a bit of patience I have generally done well by buying more during price drops. I have lost sometimes, but for most cases it has paid off well.
I’m not sure that I could ever be SURE but if I’m right most of the time that is good enough.
Even with Bear Stearns, if you sold immediately you would have sold at 3 if you wanted didn’t they revise the buyout offer to 10?
I find the idea of a PUT interesting, but I wonder if the expenses would make it a bad general strategy? Perhaps its best place for a PUT is companies you feel will either soar or crash and burn then you can try for the upside and limit your downside.
If you felt that way about a company why wouldn’t you just buy the call instead of buying the stock and a put. The cost of those equivalent positions should be the same while also giving you the same exposure to the underlying. If you interested in the math behind it just google “put call parity”.
@ Andrew – just don’t try selling a naked call 🙂
BTW: one interesting retirement strategy that I read is to buy bonds (inflation-protected) with 95% of your portfolio and put the remaining 5% into buying call options over the market. Nice.
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