What is a trailing stop?
A trailing stop is a risk-management tool. Trailing stop-losses are similar to traditional stop-loss orders, but rather than remaining at a specific price level, a trailing stop-loss follows behind the price when it moves in a favorable direction.
This helps lock in any potential profit, as the stop-loss follows the trajectory of the market price as it moves in your favor, while limiting risk by capping the potential downside.
The benefits of a trailing stop-loss
A stop-loss order is a type of order which helps manage risk by specifying a point at which your trade should be closed if the price moves against you. The key benefit of using a stop-loss is that it ensures your losses are limited. Stop-loss orders remain in effect until your position is liquidated or you choose to cancel the order.
A trailing stop, also called a trailing stop-loss, is a type of market order that sets a stop-loss at a specific percentage below an asset’s market price, rather than on a single value. The stop-loss then trails behind the stock as its price moves.
Trailing stops help to lock in profits while keeping the trade open until the instrument’s price hits your trailing stop level. Your trailing stop-loss order can be set a specific number of points or a percentage distance from the original price. When the market price reaches your trailing stop, the stop-loss order will be triggered, and your trade will be closed.
A trailing stop can also be advantageous over a regular stop-loss if the market price moves in your favor but then reverses, as your stop-loss will have followed the favorable price moves but will not move in the opposite direction.
Similar to a regular stop-loss, once the instrument’s price hits your trailing stop-loss level, your trade will be closed at the next available price, preventing you from holding on to a losing trade and being at risk of losing more money.
Example of a trailing stop-loss
Say you bought a stock at £10 per share and instead of implementing a traditional stop-loss order to sell once the price drops below £9, you set a trailing stop-loss order to 10% below market price.
In this case, if the price falls to £9, the stock is automatically sold as the price has dropped 10%. However, if the share price rises, the stop-loss rises with it, remaining 10% below the market price. So, if the share price rises to £15, your trailing stop-loss also rises to £13.50. This gives an unrealised gain of £5. If the share price dropped to £13.50 at this point, your trailing stop-loss would be triggered and a profit of £3.50 would be realised.
When to use a trailing stop-loss
Using forex trading as an example, a trailing stop-loss may be useful when trading a particularly volatile currency pair, which has erratic price moves. However, it’s important to remember that higher levels of volatility may result in your stop-loss being triggered early on.
This is why the placement of the trailing stop-loss is very important, and the historical performance of the stock and market conditions should be taken into consideration. It’s important to look at the volatility of the market over an extended period of time, as well as how it behaves on a daily basis. Placing the stop-loss too close to the market price may result in an early exit, whereas setting it too far away would mean risking more capital.
If you’re going long (placing a buy trade), then the trailing stop needs to be placed below the market price. If you’re going short (selling), then your trailing stop-loss will be placed above the market price.
In order to exit a trade at an exact price, rather than the next available market price, you would need to set up a guaranteed stop-loss order. This is a useful way to avoid slippage.
Trailing stop-loss strategy
Trailing stop-loss placement is usually specified by setting a price the desired distance away from the market price, in line with how much capital you’re willing to risk on the trade. The stop-loss will then remain this distance from the market price while the price moves in your favour. The stop-loss moves in line with favorable price moves automatically.
Some traders may choose to use a regular stop-loss in a similar way to a trailing stop, by moving it manually themselves whenever they see the market price move in a favorable direction.
Some traders may also decide to use technical indicators to guide their trailing stop placements. For example, they could use Average True Range (ATR) to understand how much the instrument they want to trade moves over a given timeframe. This gives them an indication as to how much fluctuation in the price they can expect over the course of the trading day. However, any significant unexpected volatility, such as that caused by breaking news, wouldn’t be taken into account.
The bottom line
To summarize, a trailing stop-loss is a free risk-management tool which can help maximize your profits when trading, as well as reduce the risk of making a significant loss. As the trailing stop only moves when the market price moves in your favour, it’s an effective way to increase unrealized gains, however small.
When it comes to placement, you have the flexibility to choose a price or a percentage distance from the market price, or you can specify an amount you’re willing to risk on the trade. A trailing stop-loss locks in the upside while also protecting you from the downside.
Source: CMC Markets UK