In April 2013, my custodian, TradePMR, introduced trailing stop orders (TSO) to its advisors. In this post, I'll share some lessons I've learned about TSOs and discuss the importance they play in protecting a portfolio.
The markets of the past few years have been some of the most challenging I've ever experienced. Due to the actions of the Fed, cash is paying next to nothing and bonds are subject to the risk of rising interest rates. Stocks are one of the few remaining asset classes where an investor can garner a decent return. However, if you assume too much exposure, you are subject to much greater risk. How can you accept a larger allocation in stocks and keep your risk manageable? Trailing stop orders can help.
If you're unfamiliar with TSOs here's a brief refresher. TSOs are very similar to regular stop orders with one major difference. A securities TSO 'trails' the market price of the security when it rises and remains flat when it falls. As a result, your maximum loss is limited to the initial stop percentage you select on the TSO.
Therefore, establishing a prudent TSO percentage is crucial.
Unfortunately, outside of a high-level overview on TSOs, I couldn't find any detailed, empirical data on how to determine what percentage to use. In any event, here's what I've discovered about setting the percentage on a TSO.
The first step is to define the purpose of the TSO. This may differ slightly from one advisor to another. In my case, TSOs are not used to avoid a small correction. Rather, I use TSOs to avoid more serious losses. Hence, if the TSO percentage is too small, then even a small decline can trigger a sale.
