What is a trailing stop loss? A trailing stop loss is a type of order used by traders where they set a limit – usually a maximum value or a percentage – on how much loss they are willing to incur on a particular trade. Traders use trailing stop loss orders as a way of protecting themselves from unexpected falls in the price of a security or asset.
With this simple definition in mind, in this article, we will do a deep dive on exactly what a trailing stop loss is, how they work, why traders use them, and how you can incorporate them into your own trading strategy.
A trailing stop order is one of the most common order types used by day traders to help them execute their trading strategies. By coming to grips with what they are, you will be able to progress your trading skills.
A trailing stop loss is very similar to a regular stop loss order, but there are some key differences between the two. With that said, let’s take a closer look at what it is!
What is a Stop Loss?
Before we set out what a trailing stop loss is, we should first get a basic understanding of what a regular stop loss order is.
Essentially, a stop loss is a type of order designed to help traders secure any profits they have made. It does this by protecting you from any further losses once the price has started to trend downwards.
It works by essentially capping the amount that can be lost before an order will kick in to close a trade. A stop limit is a type of order that will convert into a market order when the price of a security reaches a certain threshold – this is referred to as the ‘stop price’.
Stop orders are set to kick in automatically on the vast majority of brokers and trading platforms. They are one of the most common order types you will see, primarily as they have so many benefits as a way of protecting trading gains.
A trailing stop loss order works in a very similar way to a regular stop loss order, though there are some key differences that we will now set out.
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The Advantages and Disadvantages of Stop Orders
As we can see, stop loss orders are commonly used by traders in their trading strategies. But what exactly are the benefits of this order type?
- Stop loss orders are designed to limit the amount of loss an investor might suffer when the price moves against their position.
- Stop loss orders allow you to limit your potential losses in advance, without the need to constantly monitor your holdings to take this action manually.
However, despite these obvious benefits, there are some potential downsides or difficulties with implementing stop orders in your trading strategy:
- Short-term price fluctuations could activate the stop loss order and trigger an unnecessary sale that limits your profits.
- Prices might start to rise immediately after the stop loss has been activated.
- Figuring out what level to place a stop loss order at in advance requires a high level of knowledge and understanding.
- Beginners might not understand the markets well enough to place them properly.
Despite this, stop loss orders are a simple tool that has a number of significant benefits. With these benefits in mind, we will now look more closely at the trailing stop loss order, which is a variation of a regular stop loss order.
When Should You Use a Trailing Stop Loss?
Although it is always a good idea to implement stop loss orders into your trading strategy, a trailing stop limit has a number of advantages that make them especially useful.
Most immediately, they are useful when you are trading in a particularly volatile environment. This might be because either the asset you are trading tends to experience volatility, or because the market conditions more generally are experiencing volatility.
If you set your stop loss limits carefully, you can protect yourself from erratic price swings while also ensuring that you keep as much of your gains as possible.
Placing a trailing stop order will thus require careful consideration of the historical performance of the stock as well as a sound understanding of the current market conditions. Placing the stop loss limit too close to the current market price may result in the order being triggered too early. However, placing it too far away from current market prices opens you up to more risk.
A trailing stop loss order is thus best placed below the market when you’re going long – i.e., placing a ‘buy’ trade. Conversely, if you are going short – i.e., placing a sell order – it is best placed above the market price.
A good general strategy is to set the stop loss order away from the market price in line with how much capital you are willing to risk on that trade.
Difficulties with Trailing Stop Loss
Although trailing stop orders offer many benefits and improvements over regular stop loss orders, they still have some risks attached to them that traders should keep in mind.
Most obviously, there is a risk that they can pull you out of a trade too soon when the market price of an asset or security is only pulling back slightly. In this circumstance, there are only slight market variations, rather than an actual reversal that puts you at risk.
To avoid this, you can place the trailing stop loss far enough away from the current price at a level you think would only be reached if a true reversal were in effect.
Another related criticism is that trailing stop losses don’t protect you from major market moves that might be greater than your stop loss threshold. For example, if you set a trailing stop limit to kick in at 5% below the market price but it actually swings by 30%, then the order might not get triggered.
To get around this, some traders suggest staggering trailing stop loss orders so that there are enough opportunities to ensure that it would get activated.
Trailing Stop Loss Example
Let’s say you bought $1,000 of ABC Inc. stock.
You know from your research that ABC Inc. tends to experience pullbacks of between 5% and 8% before moving up in price.
This understanding gives you a sense of where to place the trailing stop. If you were to choose a stop order of 3% or 5%, that might be too tight. Similarly, if you were to go too far beyond 8% – for example, 20% – this might unnecessarily open you up to risk if it continues to fall beyond that and a true market reversal is underway.
With that in mind, a more effective stop loss would be between 10% and 12%. This would give you give you enough room to withstand regular market fluctuations, while also protecting you from larger drops that suggest a trend reversal.
Once the trailing stop loss order has been set at 10%, it will follow the price of ABC Inc. stock as it rises. So, for example, if the price of ABC Inc. moves up to $1,250, a sell order will kick in if the price falls below $1,125.
Conclusion
To sum up, a trailing stop loss is a type of stop loss order that is frequently used by traders as a risk management tool.
It is similar to a stop loss order, though it works slightly differently by setting a threshold that follows the current market price. In this sense, rather than being set at a specific point, it allows the stop order to deal with market fluctuations and volatility while still offering protection.
Trailing stop loss orders are more flexible than regular stop loss orders and will not need to be manually reset.
Despite these benefits and this flexibility, however, you will still need to closely monitor the markets even when you have a trailing stop limit in place. Always decide on entry and exit points in advance and never over rely on these order types if you sense a shift in the market – particularly where the market is peaking or hitting new record highs.
With this understanding in mind, you are now equipped to implement one of the most commonly used order types in your own trading strategies. Executing an effective trading strategy requires you to understand all of the order types at your disposal.
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