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Monday, August 24, 2009

Trailing Stop-Loss in Stocks Part-1

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The most basic technique for establishing an appropriate exit point is the trailing stop technique. Very simply, the trailing stop maintains a stop-loss order at a precise percentage below the market price (or above, in the case of a short position). The stop-loss order is adjusted continually based on fluctuations in the market price, always maintaining the same percentage below (or above) the market price. The trader is then "guaranteed" to know the exact minimum profit that his position will garner. Here, the stop-loss order is set at a percentage level below not the price at which you bought it but the current market price. The price of the stop loss adjusted as the stock price fluctuates. Remember, if a stock goes up, what you have is an unrealized gain, which means you don't have the cash in hand until you sell.

Using a trailing stop allows you to let profits run while at the same time guaranteeing at least some realized capital gain. To use our Reliance example from above, say you set a trailing stop order for 10% below the current price, and the stock skyrockets to $ 80.00 within a month. Your trailing stop order would then lock-in at $ 72.00 per share ($ 80.00 - (10% x $ 80) = $ 72). This is the worst price you would receive, so even if the stock takes an unexpected dip, you won't be in the red.

Limiting Losses - It is simply not possible for any trader--whether amateur, professional or anywhere in between--to avoid every single loss. The disciplined trader is fully cognizant of the inevitability of losing hard-earned profits and, as such, is able to accept losses without emotional upheaval. At the same time, however, there are systematic methods by which you can ensure that losses are kept to a minimum.

A 2% Limit of Loss A common level of acceptable loss for one's trading account is 2% of equity in the trading account. The capital in your trading account is your risk capital, the capital that you employ (that you risk) on a day-to-day basis to try to garner profits for your enterprise. The loss-limit system can even be implemented before entering a trade. When you are deciding how much of a particular trading instrument to purchase, you would simultaneously calculate how much in losses you could sustain on that trade without breaching your 2% rule. When establishing your position, you would also place a stop order within a maximum of 2% loss of the total equity in your account.

Of course, your stop can be anywhere from a 0% to 2% total loss. A lower level of risk is perfectly acceptable if the individual trade or philosophy demands it. Every trader has a different reaction to the 2% rule of thumb. Many traders think that a 2% risk limit is too small and that it stifles their ability to engage in riskier trading decisions with a larger portion of their trading accounts. On the other hand, most professionals think that 2% is a ridiculously high level of risk and prefer losses to be limited to around half or one-quarter of a percent of their portfolios. Granted, the pros would naturally be more risk averse than those with smaller accounts--a 2% loss on a large portfolio is a devastating blow. Regardless of the size of your capital, it is wise to be conservative rather than aggressive when first devising your trading strategy.

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