Dynamic Trailing Stops

The following describes how I usually manage the risk of a trade as it appproaches a price target:

Some successful traders say it matters less where one enters or exits a trade than how one manages its risks. One way we can keep risk tightly under control as a stock moves up or down is to use dynamic, or risk-adjusted, trailing stops. How do they work? To illustrate, let’s take the example of a trader who buys a hundred shares of XYZ stock at $62.00, with the intention of selling it when it reaches $65.00.  In this instance the expected gain is $300, or $3 per share. But how much risk is acceptable? The answer, both initially and as the trade progresses, will depend on how and under what circumstances the trader determines to exit the position.

For instance, a prudent trader might decide before initiating a position that, once on board, he will risk no more than $1 to make $3 at any point along the way. Thus, with a target of $65, if he is able to buy 100 shares of XYZ for $62, he should use a $61 stop-loss initially, limiting theoretical loss to $1. (The risk is theoretical because in practice there is no assurance the trader will be able to get out of the position at the predetermined price. In fact, stop-loss orders are often executed at prices far worse than intended.) In this example, the stop-loss at $61 is referred to as “fixed” because it will remain unchanged as XYZ moves up or down within certain limits.

But let’s suppose the stock rises straightaway to $63.50. At that point the trader would have an unrealized gain of $1.50 per share, with additional profit potential of $1.50 per share (assuming as before that XYZ reaches its $65 target). Thus, with XYZ trading at $63.50 and a fixed stop-loss at $61, the trader’s risk:reward parameters will have changed for the worse, since he would then be risking $2.50 per share to make an additional $1.50. To bring risk and reward back into proper balance, the trader would need not only to raise his stop-loss, but to shrink it in proportion to the remaining potential gains. In this case, restoring a 1:3 relationship between risk and reward would require raising the stop-loss to $63.00.

Let’s do the math. XYZ is at $63.50, promising an additional $1.50 per share of profits if it reaches $65. However, if the stock should fall back to $63.00, where we’ve placed the new stop-loss, the trader would lose 50 cents per share of his paper gains. That is the same as saying risk:reward is 1:3, so the trader is back on track. In practice, the trailing stop will need to be raised each time the stock moves closer to the target, and it will also have to be narrowed in proportion to remaining expected gains. Thus, if the stock climbs to $64.50, it will require a stop at $64.33 to maintain the 1:3 relationship between risk and reward. This is risk management at work, using a technique that can be applied to any trade.