In last week’s blog we discussed some of the reasons why it may be beneficial to use ETFs instead of mutual funds. We also discussed the added flexibility ETFs offer in terms of buying and selling. We concluded with a brief mention of trailing stop orders, which cannot be utilized with mutual funds. In this post, we’ll dig deeper into using TSOs in conjunction with ETFs and the protection they offer.
Trailing Stop Orders
Trailing stop orders are essentially a stop order that rises with (i.e., trails) the price of an investment. They are entered as a percentage of the investments initial purchase price. For example, if you buy an ETF at $10 per share, and add a 5.0% TSO, if the price were to fall to $9.50, it would trigger a sale, thereby limiting your loss to 5.0%. That describes a stop order. However, if the price of the investment were to rise, the stop price would rise with it, maintaining a 5.0% lower bound.
Therefore, if the price of your investment rose to $15.00 per share, assuming it hadn’t triggered a sale beforehand, the new stop order would be $14.25, which is 5.0% below its current price of $15.00. At this point, the new stop order of $14.25 would be above the the original purchase price of $10.00, hence, if the price were to decline and hit $14.25, it would sell and you would have a profit of approximately $4.25 ($14.25 – $10.00 = $4.25) per share.