The Hindu Business Line : Using a trailing stop loss

Not many of us would have expected, even in our wildest imagination, that the markets would post a increment of over 50 per cent at the fastest pace in five years.That leaves us with questions — Have the markets overdone it? Is there more to come? And, most important, how do I harness this speedy bull?

The situation becomes really sticky when you have an unprecedented rally that now appears to have enough headroom to get an extension. Some traders may have remained on the sidelines throughout this rally. Others may have invested at one point in the rally and get out at the perceived optimum level, losing the opportunity to capitalise on the rest of it. The solution to reduce such anxiety and to make the best of a rally lies in the mechanism called trailing stop loss. Let’s understand what it is and how it works.

Setting targets

The idea in trading profitably is to ride a trend till it lasts. Assuming one decides to buy into a bull market with the possibility of losses covered by a stop-loss.

A prudent investor then gets out once the perceived price objective is achieved, losing a chance to make any money out of gains over and above his target. Now the question is how high to set the target?

The answer lies in tweaking the argument a little by selling at a trailing stop loss, rather than at a target price. The idea is to raise the exit barrier in the direction of trade instead of setting an absolute limit on the rise. One of the major benefits in keeping a trailing stop loss mechanism is that as you near the target the stop-loss is revised upwards, locking in profits at the escalated stop loss level.

There are many benefits of this little alteration to a selling strategy. Many a time a sharp rise in a stock will be punctuated by minor corrections, that lead to enough nervousness to induce an exit.

Keeping a trailing stop loss takes care of this nervousness. By compromising a fraction of profits one creates an opportunity to make as much money as the market allows him to make.

Trading positions

It will be easier to understand this concept with a live market example. A trend follower would have been a seller in early March 2009. As March moved along, towards the middle of the month, many realised that the Sensex may continue the sudden bout of gains, prompting fresh trading buy positions.

Let’s say one initiated a trading buy with a stop loss of 8,300 for a target of 9,000 when the Sensex was trading at 8,450. In the penultimate week of March, the Sensex realised the target. While a target seller would have exited the position, a trailing stop-loss follower would have raised the stop loss to 8,600 then.

The Sensex moved at an even faster pace, raising a trailing stop loss to 9,000, 9,300 and 9,700, which finally got hit realising 700 points more than the original price objective of 9,000.

A similar example can be cited from the current move in April where, had one used a target-based selling strategy, one would have achieved the target and missed out on an extended rally. A trader using a trailing stop loss would still be hanging on to trading buy waiting for newer highs to be conquered.

Moral of the story, let the market decide when the money you made is enough.

(The author is Associate Director, Motilal Oswal Financial Services.)

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