The Hindu Business Line : Trader's Corner

Many of us would be familiar with the situation in which a stock that has been pushed to the back of our minds and to the back of the most unused cupboard starts zooming up suddenly. We do not want to see all the profit whittle away again.

The way to solve this quandary is by using trailing stop losses. Trailing stop loss is nothing but another form of a stop loss order. Assuming that a stock has been bought and the trade has moved into profit, the trailing stop loss order is calculated using a certain percentage from the most recent high. As the price moves up, the trailing stop loss, too, moves higher. But when the price moves lower, the trailing stop does not move lower and so gets triggered when the trend reverses.

The reverse is true in a short selling. The trailing stop loss would be a fixed percentage from the most recent low. It will move lower as the price moves lower. But if the trend reverses and the price moves higher, the trailing stop would not move and so the trade would get stopped out.

Let us explain this concept with an example. If 100 shares of Reliance were purchased at Rs 1,000 and a 2 per cent trailing stop loss is decided upon. If the price moves to Rs 1,050, the trailing stop would be at Rs 1,029. If the price moves to Rs 1,075, the trailing stop would be at Rs 1,053. If the price moves to Rs 1,200, the trailing stop would be shifted to Rs 1,176. If the price reverses from Rs 1,200 and falls to Rs 1,070, the trailing stop at Rs 1,076 would get triggered and a profit of Rs 76 would be booked.

The moot question is what the trailing stop loss percentage should be. Day traders would keep a trailing stop of 0.5 per cent or 1 per cent; swing traders might keep a 2 per cent trailing stop. Investors with a shorter time frame can ideally keep a 5 to 7 per cent trailing stop if their stock starts zooming up in an unexpected fashion.

The second factor that would determine the percentage of the trailing stop loss limit would be the volatility of the stock that has been purchased. A sedate stock that does not see too great an intra-day movement would require a lower trailing stop whereas a volatile stock would require a larger trailing stop percentage.

Traders who use technical analysis can use the parabolic SAR indicator to tell them when a trade can be exited, as it calculates the trailing stop loss for the stock. But this indicator would prove to be ineffective in stocks that are not trending but are moving sideways, instead.

Lokeshwarri S. K.

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