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‘Trailing stops’ let your winners run

By Dr. Don Taylor · Bankrate.com
Monday, October 28, 2013
Posted: 6 am ET

I love investment adages. That's a blog post for another day. The adage for today is: Sell your losers and let your winners run. That type of advice can be extremely relevant as we close in on the end of the year and investors consider selling out of losing positions and harvesting tax losses in their taxable investment accounts.

Since net capital losses are limited to $3,000 in a year although higher net losses can be carried forward into future tax years, the decision becomes whether to take some money off the table in positions with gains.

What's really on the table today isn't tax harvesting but the use of a trailing sell stop-on-quote order, called a "trailing stop" order, to give you the confidence to let your winners run. Retail stock market investors should learn about all the different types of orders available to them in their brokerage accounts. The trailing stop is just one such order.

With this type of a trailing stop, the investor stays invested in the stock until the stock backs off from its current price when you place the order or its subsequent highs, either on a percentage basis or as a fixed-dollar amount. That's because the trailing stop resets itself as the stock price heads higher but doesn't reset lower if the stock price falls. If the stock price falls off and touches the trailing stop price, the trade becomes a market order and the investor is sold out of the position.

There's no guarantee that the trade will execute exactly at the stop price because the order will execute at the market price. But in a liquid market, the shares will trade very close to or at the stop price, which is based on the bid price in the market for the stock. (Stocks trade on a bid-asked spread, which is at least a penny. Buyers are willing to pay the bid. Sellers are willing to sell at the asked or offered price.)

As an example, say Apple stock currently trades at $500 per share. If you own 100 shares and want to stay invested in Apple as long as the stock price doesn't fall by more than 5 percent, you could place a 5 percent trailing stop on Apple. If Apple stock trades no higher, the stop level is $475. However, if Apple stock trades up to $550, the trailing stop level would be $522.50. If it trades up to $600, the trailing stop is set at $570. Alternately, you can set the trailing stop as a dollar amount, say $25, and the trailing stop will continually reset to $25 less than the stock's high after you placed the order. In both types of trailing stops, the stop price adjusts upward as the stock price goes up but doesn't go lower when the stock price goes down.

One important consideration in placing the trailing stop is that you need to set the time parameters on the order. A good-til-canceled, or GTC, order stays in place until you change the order, although some brokerage firms may limit how long a GTC order can be in effect.

You should be careful in setting your stops. You don't want a hair trigger on your stop, or you'll get sold out of your position and might regret no longer owning the stock if a price downdraft is a temporary blip. You'll also want to consider tax effects when trading in a taxable account, including the rules on "wash sales" when you repurchase shares within a 30-day period.

Do you use trailing stops in your account? What's your plan for tax loss harvesting in your account this year?

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