Option Letter Daily

Question: What is the recommended loss percentage in a trailing stop?

Answer: Good question. What the reader is referring to is a specific type of exit methodology. A trailing stop is a stop-out level that changes every day, along with the price of a stock or index. The idea is to let a good trade ride as long as things are going the right way, and scoot the stop level upward along with the stock, just slighty below it, so as not to interfere with the natural ebb and flow of a chart. When things reverse, your trailing stop level should be close enough to the current price to get you out quickly if things turn sour, but not so close that it might get you out of a trade too soon just due to a little volatility. The nice part about these kinds of stops is that they are often automated, if your broker will allow them.

The question specifically is asking how much loss should I tolerate from a high point (or peak) in a trade to a low point in the trade? Or to say it another way, how much of a percentage drawdown can I accept before I pull the plug on a trade?

To answer the question: it depends. Some stocks are volatile and need a lot of wiggle room, where other stocks are consistent and should be played tight. Indexes can behave both ways. So the question really is how much room do you need to allow for your style of trading? We back-tested a variety of stocks and indexes, and the optimal trailing-stop percentage for us was anywhere from 4% to 12%. But is seems like the best overall results occurred when we used 6%. For an index, it was slightly less.

Did we just give away a proprietary secret? Nah, anybody with back-testing software could have done the same. Plus, getting the right trailing-stop is only one of numerous things that has to be “just so” for system-based trading. However, we hope that little tip helps.

Price Headley is the founder and chief analyst of BigTrends.com.