A trailing stop loss is very similar to a stop loss, but wherethe one kept your losses small, the trailing stop loss willenable your profit growth.
A trailing stop loss is calculated in a manner like the way wecalculated our initial stop loss. The only difference being thatwhile we calculated our stop loss from the entry price, we`recalculating our trailing stop loss from the highest price sinceentry. The key to the trailing stop loss is that you need tomake continual adjustments to make sure that the stop is movedin your favour.
The method that you use to set your trailing stop loss can varydramatically. However, if we use the ATR method that we used tocalculate our initial stop to set our trailing stop loss, we`llhave the ability to lock in the profit as the share priceincreases.
For example, if you bought a share at one dollar, and yourinitial stop was set at 90 cents, your trailing stop would alsohave a value of 90 cents. If, after the first day, the shareprice moves in your favour and moves to $1.10, you wouldrecalculate your trailing stop loss by subtracting two times thevalue of the ATR from the new high price of $1.10. Forsimplicity, let`s assume that your stop size hasn`t changed, andis still ten cents wide. When you calculate your new trailingstop loss, by subtracting the 10 cents from $1.10, it would beset at one dollar.
At this point, your initial stop was at 90 cents, and yourtrailing stop loss is now at a dollar, with the share price isat $1.10. Since your trailing stop loss is higher than yourinitial stop, the initial stop becomes obsolete, and ourtrailing stop loss becomes your active exit.
Now, my question is, How much profit have you made on thistrade?” The share price is at $1.10 and we entered at onedollar. If you thought, No, I haven`t made any money”, thenyou`d be right on track. Remember, our stop loss strategy givesthe share price a little bit of room to move.
You`re not going to exit this position until the share pricereverts to one dollar. It`s important to note that when you arevaluing any open position, you should always value it based onits stop loss value, since if you were to exit this share, youwould wait until that price point was breached.
Let`s go back to the example. Now, what happens if the shareprice begins to fall? Let`s say that the share price falls from$1.10 down to $1.05. What does your trailing stop loss do? Wouldit move down also? Here`s another important point. A stop losswill never, ever move down. A trailing stop loss can only moveup. This ensures you lock in profit and that you`ll also get outof the shares once they start to turn. A trailing stop loss isalways calculated from the highest price since entry, so thehighest price is still $1.10.
It`s not until the share price makes a new high since entry thatthe trailing stop loss would begin to move in your favor again.However, if you`re using the ATR method, there`s another way forour trailing stop to move up. This would occur when thevolatility of a stock begins to decrease. If a share price wereto begin to move sideways, the ATR value would start to dropoff. This would cause the trailing stop to move up as the shareprice became less volatile.
The best way to understand these concepts is to print out achart with the ATR values along the bottom. Then on the chart,identify the point where you would have received an entrysignal, and mark your initial stop loss and your trailing stoploss.
As the trend progresses make sure that you recalculate the valueof your stop so you can begin to get a feel for the way thismethod of using a stop loss works Seeing how the changes instock price affect you trailing stop loss will give you theconfidence to make them a key part of your trading system.
About the author:
Trading Secrets Revealed is a step-by-step trading roadmap tohaving excellent money management. http://www.trading-secrets-revealed.com
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