How does the trailing stop system work?

We use volatility-based trailing stops in our Trend Following portfolio. That means our stop losses are based on the volatility of the stock we’re buying. They move up when our stock’s share price does, to follow our trend and lock in our gains (but they don’t move down, even if the stock does).

Think of it this way… imagine you use a set percentage stop of 10% and you’re buying two new trades. One is very volatile and swings 15% in either direction in any given week. The other is much less volatile, moving only 5% a month on average.

With a 10% trailing stop, you’re likely to get stopped out of the first trade almost immediately, while exposing yourself to far more risk than you need to on the second trade. Percentage-based trailing stops are totally arbitrary — and that’s why we don’t use them.

Who’s to say that a 10% stop is a good idea? Or 5%? Or 25%?

Instead, our stops are designed for one thing and one thing only: to keep us in a trend as long as possible without exposing us to unnecessary risks.

With our stop loss system, we give more volatile stocks a wider berth. And we keep our stops tighter on trades that don’t move as much. Doing that minimizes the impact of market noise on our trades.

And it meaningfully improves the profitability of our system.

One final thought on using stops: I’d recommend that you never use “hard stops” that trigger sells in your portfolio automatically when a stock hits a preset price.

Algorithmic trading systems have been known to sniff out price levels at which lots of investors have stops set and send out big short orders to try to trigger those sell orders, taking gains once the unsuspecting investors’ stop losses have all been tripped.

Likewise, when a stock you own trades below your stop price for a nanosecond, it’s more or less guaranteed that you’ll be the only person stopped out on the trade.

Your better bet is to wait for confirmation of a valid stop signal and then submit the trade yourself. Even if it costs an extra couple of points on every trade, the money saved by avoiding whipsaws and high-frequency trading attacks will more than make up for it.

And as always, we’ll send you a flash alert immediately whenever a new buy or sell signal triggers in the Trend Following portfolio.