As an investor, you should be familiar with a stop-loss, or the order given to a brokerage to sell a position once it drops by a certain amount or hits a certain level.
However, a trailing stop-loss adjusts higher as the price of an asset rises, thus allowing the investor to lock in gains.
For example, if a long position were bought at $10 with an initial 25% stop-loss set at $7.50, the trailing-stop would rise in tandem with the asset.
Trailing stop losses are essential in today's trading environment.
Say you bought Arena Pharmaceuticals (ARNA) at $6 a share ahead of an FDA decision on obesity drug, lorcaserin.
As it pushed toward $9.00 a share just weeks later, you begin to get a bit nervous that the run is coming to a near-term end...
To protect your gains should the bottom begin to fall out, you can use a 10% trailing stop-loss.
In this case, you'd set your trailing stop-loss at $8.10 ($9 x 10% = 90 cents; $9 – 90 cents = $8.10).
This way, should the run end, you still lock in a solid gain of 35%.
If the stock continues to head north, nothing happens. The trailing stop-loss isn't triggered.
However, if the stock turns south and hits that trailing stop-loss, the stock is sold — and you pocket the profit.
It's a safe, easy strategy that should be part of all portfolios.