Set Your Trailing Stop Order Below Support

Provided By Ultimate Trading Systems

When To Set Your Trailing Stop Order

The one fairly specific rule in a trailing stop order - the "science" part - is that you should not set them either right on the position’s support level or just above support. Instead, unless the support level is so low that setting the trailing stop order there would lose you too high a percentage of your capital, set your trailing stop order below support.

A support level is a price at which the position has previously bounced (reversed its downward course). Think of it as a potential floor. The reason it's so important to set a trailing stop order below support is that positions moving downward tend to bounce upward (reverse course) at or near their support levels. They may later begin to move downward again, break through support, and continue to move even lower.

A clear break below support is dictated by where a position closes, not by intra-day swings. Alternatively, after bouncing off support, a position may continue to move upward, never returning to the support level at all. For purposes of setting a trailing stop order, it doesn't make sense to set a trailing stop order right at support because the position is almost certain to bounce up from that point, possibly reversing course. If you set your trailing stop order below support, it probably won't be triggered unless the position has broken support and will continue downward.

The same principle applies for a stop buy-to-cover on a short position: Set your stop above, not at or below, resistance. A resistance level is a price at which the stock has previously reversed its upward course. Think of it as a potential ceiling.

Examples Of A Protective Trailing Stop Order & A Trailing Trailing Stop Order
Here's an example to illustrate the reasoning behind decisions about where to set protective and trailing stop sells.

Protective Trailing Stop Order
First let’s illustrate the importance of setting stop sells below support: Let's say you take a long position in a stock in anticipation of its earnings announcement. It had traded at around 13 for many weeks, but last week it ran up to 16, probably as the first sign of its earnings run. It then slowly dropped to 14.40 over the course of two days and stabilized there for a day and a half. Today it's started to slowly move up again, and you think it'll keep going. You decide now's the time to buy. You put in a limit buy order at 14.8, and it executes at 14.76.

Since it isn't the strongest company in the world and the market has been flat, you want to set a reasonably tight protective trailing stop order. You don't want to set it too tightly, though, since the stock isn't very volatile and the time frame for your trade is about five days. You look to see where the stock has support.

There are two support levels: 13, where it traded for weeks, and 14.40, where it stabilized recently. Its resistance level is 16. If the stock moves down from where you bought it, it will almost certainly bounce at 14.40.

If the stock then drops below 14.40, you assume that would indicate it isn't ready to move up yet, and you'd be better off setting your trailing stop order out there and re-buying later. For this reason, you also determine there's no reason to let the stock move all the way down to 13. Since its support at 13 is very solid, any drop through the floor at 13 would mean a real weakness had developed in the stock.

You decide to set a protective trailing stop order at 13.75. You don't want to set it right at 14.40, since it's almost sure to bounce near 14.40 and then either start back up or continue down. You don't want to set it above 14.40 for the same reason. You choose 13.75 because no support level is absolute, and it could bounce off 14.30, 14.50, or any number close to them as easily as it could bounce off 14.40. If the stock gets as low as 13.75, though, that would suggest that the stock will actually break through support. (Remember, the rule is that a clear break of support is dictated by where a stock closes, not by intraday swings.)

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