John bought stock X, and it has gone up (yay!).

John suspects stock X is near a peak. His options are:

  1. Do nothing and see what happens (not interesting to this question)
  2. Sell and take the profit
  3. Set a trailing stop loss, say at 99% of the current market price

Option 2 has the downside that, if stock X goes down directly, John will lose 1% of the current market price, which may be a significant chunk of his profit. On the other hand, the probability that he loses more than 1% is 0, while there is a >0 probability that stock X increases more than 1% before it goes down, yielding John even more profit. Since he cannot know what happens next, it seems the balance of probabilities always points to using trailing stop loss.

I could not find any guides on when to just sell instead of setting TSL. Is there a method to choose what to do, or is it just straight gut feeling?

  • 4
    "On the other hand, the probability that he loses more than 1% is 0" That's not true. A drop of 1% triggers the stop loss at the broker, and only then a market order is placed. If the price drops by 5%, this value is used. – glglgl Jul 17 '20 at 9:24
  • That's a good point - large overnight drops make SL useless. Netflix seems to be doing that right today. – Makotanist Jul 17 '20 at 10:05
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    Shouldn't he make it 98%? After all, what if the stock goes down 1.5% and then up 5%? Actually, it could go down 2.5% and then up 5%, so better make it 97%...... – user253751 Jul 17 '20 at 10:21

A 1% stop loss order is only effective if price retracement is orderly. If prices gaps down, the execution price can be much lower than where the stop was set. Therefore there's no guarantee that one gets 99% of current market price with a 1% trailing stop.

If price retracement is orderly and the stop loss order takes you out at 1% lower than the current market price, that 'give back' will not be a significant chunk of an existing profit unless that profit was less than 1% of current price.

Selling immediately locks in the gain and terminates participation. A trailing stop loss allows ongoing participation but at the risk of potential loss. That's the trade off. Which one will be more effective depends on what share price does going forward.

A third possibility that you did not mention was that if the stock offers options, you can lock in the gain in several ways. If you are wiling to cap profits, a low/no cost Collar will have a hard stop in place while providing a limited amount of additional potential upside gain.

  • You know, inexperienced traders should be supplied with a ten-foot-high sign, "STOP ROFL ORDERS ARE MARKET ORDERS". – Fattie Jul 17 '20 at 13:54

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