Protecting Your Account with a Trailing Stop Ladder

| May 20, 2013 | 0 Comments

Investors have multiple choices on how they can protect their accounts from major losses in a bear market.  One of my favorites and most often used methods is a Trailing Stop Ladder.  A trailing stop allows an investor to place a limit order that moves higher as the stock (or ETF) moves higher.  The order can trail the price as a percentage or a flat dollar and cents amount.

If the trailing stop order is in dollar terms, the limit order price to sell rises, penny for penny, with each tick higher for the stock.  For example, if Boeing (BA) is trading at $98.50 and an investor enters a trailing stop to sell if BA drops $5.00, the order would be triggered if BA fell to $93.50.  However, if BA rose to $120.00 before turning lower, the order would be triggered at $115.00, $5 below the high price for the stock.

If the trailing stop order is in percentage terms, the limit order price to sell rises, as a percentage, with each tick higher for the stock.  For example, if Boeing (BA) is trading at $98.50 and an investor enters a trailing stop to sell if BA drops 5.0%, the order would be triggered if BA fell to $93.58.  However, if BA rose to $120.00 before turning lower, the order would be triggered at $114.00, 5.0% ($6.00) below the high price for the stock.

The biggest risk using any type of limit order is that the stock could have a brief drop and then push higher again.  During the dip, an investor using a limit order, such as a trailing stop, could sell at a low point and then not own the stock on its recovery without making another trade.  To mitigate this risk somewhat, investors can "ladder in" their trigger levels.  The first trailing stop can be relatively small as a percentage of shares owned, just to slow the losses on a decline.  If the stock reverts higher, not much of the gain is missed.  If the stock continues to fall, additional trailing stops can be hit that had wider margins.  For example, if an investor owns 500 shares of SPY (an S&P 500 Exchange Traded Fund), he could place the first trailing stop for 100 shares at a 5.0% trail.  The next trailing stop could be for 150 shares at 7.5% lower and then 250 shares at 10.0%.  In this case, any correction greater than 10% would not cause the investor further losses.  If SPY only dipped down for a 6% loss before recovering, only 20% of the investor's position would have been cut, leaving 80% in the account to regain the losses sustained on paper.

It is important to note that just because a trailing stop is in place doesn't mean the order will sell at the investor's target price.  If the trailing stop triggers a market order, the trade might not occur until the stock has fallen further.  This is more common at the market's open than any other time of day when stocks tend to slide lower rather than "gap" lower.  The example above is an illustration of how a trailing stop ladder can work.  The percentages or dollar trailing levels can and should be adjusted for each investor's risk tolerance and goals.

Ask your advisor what strategies he/she uses to limit your losses during a bear market.  Diversification is not enough protection when all asset classes fall.  If you aren't satisfied, talk to an AF Capital Management Advisor.

Filed Under: Investing 101


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