A Trailing stop loss order encompasses a special type of trade, where, rather than stop-loss price being set on a single, absolute dollar amount, the price is set at a certain percentage or a defined dollar amount below the market price.
This is sometimes referred to as a trailing stop.
Trailing stop losses combine elements of both trade management and risk management. They are also known as profit protecting stops.
This owes to the fact that they help lock in profits on a trade while capping the amount that will be lost should the trade fail to work out.
Trailing stops can be automatically set up with most brokers or software, or manually implemented by the trader. It ‘locks in’ profits as the price rises in your favor.
How Does a Trailing Stop Loss Work?
Initially, a trailing stop is placed in the same manner as a regular stop loss order.
For instance, a trailing stop for a trade would be a sell order, and it would be placed at a price below the trade entry.
The main thing differentiating a regular stop loss from a trailing stop is that the trailing stop moves with the price. I.e. For every 5 cents that the price moves, the trailing stop will increase by 5 cents.
In other words, trailing stops only move in the direction of the trade.
However, if the price falls, the stop loss doesn’t move.
If the entry point of a trade is at $50, a 15 cent trailing stop loss will be placed at $49.85.When the price moves up to $50.15, the trailing stop moves to $50.Should the price move up to $50.30, the trailing stop moves to $50.15 an if the price reduces to $50.25, the trailing stop will stagnate at $50.15.If the price reduced down to $50.15, then the trailing stop will exit the trade at $50.15, having protected the 15 cents profit.
The same applies to a short trade, only that we will be expecting the price to drop; therefore, a trailing stop loss is placed initially above the entry price.
If for instance, a short trade enters at $30, with a trailing stop-loss of 20 cents. We are stopped out with a 20 cent loss if the price moves to $30.20, and should the price drop to $29.60, our stop loss will drop to $19.80.If the price goes up to $29.70, our stop loss will remain where it was, and if the price falls to 29.40, our stop loss will fall to $29.60
This means that if the price rises to $29.60 or higher, we’ll be stopped out of the trade with a profit of 40 cents.
Advantages and Disadvantages of Trailing Stop Loss
- Placing a stop-loss order doesn’t have a cost
- This order allows investors/traders to stick to predetermined goals and take emotions out of a trade.
- Flexibility. The trailing stop-loss order is flexible, meaning that you can enter any trailing stop-loss proportion for a customized risk-management plan and change it however you please.
- There are no caps put on profits. For as long as prices don’t dip by your predetermined percentages, shares can continue to rise, and you will stay invested.
- This order will automatically sell your stock/currency pair when the desired levels drop. This gives you peace of mind when you are away from your trading platform during significant dive in prices.
- You will lose the ability to make any thoughtful and analytical decisions as to whether to sell the stock/currency after a drop of prices when you may otherwise judge the drop as nonsensical.
- Receiving the price of your stop-loss order is not a guarantee. When the drop of stock/currency prices happens fast, your order may not get filled at your intended stop price. This may compel you to sell at a price lower than what you expected. This often happens with fast-moving markets or illiquid stocks.
- Volatile stocks may prove difficult to trade with trailing stop-loss orders. You will be liable for significant losses if you set an order that’s too low to account for potential fluctuations. If you set the order too high however, you may end up unwillingly selling the stock due to normal changes in prices at a time when you might better hold on to the stock. (Use ATR to assess Volatility)
- Some of the brokers in the market won’t allow for stop-loss orders for specific stocks or exchange-traded funds.
Concluding Remarks on Trailing Stop Loss Orders
Some of the traders use trailing stops in every single trade they make, whereas some never use them at all. You choose what you want.
Profit targets can be used in conjunction with or instead of a trailing stop loss. Set up a stop-loss to automatically move or you can manually adjust the stop-loss yourself.
Do not set a trailing stop loss too close to the entry. This is likely to result in a premature exit.
The main purpose of the trailing stop loss is to capture profit as the price moves in your favor and to exit a trade if the price reverses.
When effectively used, it can be such an effective tool that can help you liquidate a position with either a profit or limited losses.
But first, take into consideration the overall volatility of the market and the stock/currency pair before setting your order.
Also, decide whether you would like to be in a trade for the long-term or a short-term.