Trailing stop loss is an excellent stop-loss strategy to limit large losses, thus boosting your returns. In general, stop-loss strategies help reduce sudden downward movements in your portfolio’s value. But is a trailing stop loss any good, and does it really work?
A trailing stop loss is good because it lets you set the maximum percentage of loss you’re willing to incur. It reduces your trading risks by reducing the instances of uncontrolled downward movements in the value of your trading portfolio. It also allows you to lock in your profits resulting in increased market gains.
Keep reading to learn all about trailing stop loss, including:
- How a trailing stop loss works.
- When and how to implement trailing stop loss in your trading strategies.
- The pros and cons of using a trailing stop loss.
So, without further ado, let us get started.
IMPORTANT SIDENOTE: I surveyed 1500+ traders to understand how social trading impacted their trading outcomes. The results shocked my belief system! Read my latest article: ‘Exploring Social Trading: Community, Profit, and Collaboration’ for my in-depth findings through the data collected from this survey!
Table of Contents
What Is a Trailing Stop Loss?
A trailing stop loss refers to an order that allows you to put in place a maximum percentage or dollar value of the loss you can take on a given trade.
The goal is to help you lock in profits while protecting you from losses that can occur during trading. As such, the trailing stop loss sets a cap on the amount that you can lose if the trade fails. However, it doesn’t cap the potential gains if the trade works in your favor.
How Does a Trailing Stop Loss Work?
What differentiates a standard stop loss from a trailing stop loss is that the former moves each time the price moves in your favor. Thus, for every 10 cents that the price goes up, the trailing stop moves a corresponding 10 cents up. However, if the price starts falling, the stop loss won’t move back.
In general, a stop-loss order helps to control the risk in trading. It enables you to exit a trade if the price of your security moves in the opposite direction, hitting the price the stop-loss order is set at.
On the other hand, the stop price on a trailing stop loss moves as the market price moves, but only if the market is moving favorably. However, it stays put when the market moves against you. This means when the asset price goes up or down in your favor, the stop price moves too. But if the asset price rises or falls against you, the stop remains in place.
To illustrate this, let’s consider the below example:
If you buy a certain stock at $50.15 and set a regular stop-loss at $50.05, you are risking $0.10 per share. If the price drops down to $50.05, the stop-loss order will automatically execute to get you out of the trade. The stop-loss order doesn’t move; it stays as is irrespective of the price going up or down.
But when you place a trailing stop-loss order, then you can move the stop-loss as the price moves if the need to reduce risk arises. So, if the price goes up to $50.25, then your new stop loss will be at $50.15.
Note that your trade gets affected at the currently available market price, meaning the execution could occur at a price either above or below the stop price.
How Do You Implement a Trailing Stop Loss Strategy?
When placing a trailing stop-loss order, you usually follow the same procedure as you would when placing a standard stop-loss order.
For instance, a long trade trailing stop would be a sell order placed at a price below the trade entry point, while for a short position, your trailing stop is set at an amount higher than the current market price.
You can implement trailing stop-loss orders using several techniques. These include setting up automatic orders with your broker or manually adjusting your stop-loss orders based on price movements, trading volumes, or other technical indicators.
Most trading platforms usually feature the price-based trailing stop-loss, while experienced traders prefer using the manual version since it offers more flexibility. In this case, you set a regular stop-loss order, then decide when and where to move the stop-loss order to lower your risks.
You can set trailing stops as either market orders or limit orders. Market orders allow you to buy or sell financial assets at the best price possible while limit orders enable you to do so at a specific price, or even better. For the latter, this means your order will execute at the specified limit price or lower while the sell limit order executes at the limit price or higher.
To set a trailing stop-loss order in motion, you first need to determine how much space to give your trade (a percentage or dollar amount). You then double-check your order. From this point, your stop loss should move as the price moves. You can also trail your stop loss manually by changing its price as the price moves, as mentioned earlier.
For indicator-based trailing stop-loss, you need to move the stop-loss manually to reflect the new market conditions. Most trailing stop-loss indicators base their readings on the Average True Range (ATR), which computes how much an asset moves within a given duration.
Does Trailing Stop Loss Work?
Trailing stop loss works because it lets you ride a trend safely while giving you an effective exit strategy. In addition:
- It can lead to significant gains. When a big trend develops, much of it gets captured for profit—if the trailing stop loss is not hit. This means that if you let your trades run until they hit the trailing stop-loss, you could earn considerable profits.
- It can help prevent a winning trade from turning into a loss. A trailing stop loss is also helpful when a price moves favorably only to reverse. It helps minimize the amount of the loss if a trade fails to work out.
Cons of Trailing Stop Loss Orders
They Don’t Always Work
Markets aren’t perfect, and sometimes the price can make a sudden sharp move, hit your trailing stop-loss, but proceed to move favorably without you.
This makes you lose out as you fail to benefit from favorable price moves. The same thing can happen when the price keeps fluctuating: trailing stop-losses can lead to several losing trades since the price keeps changing and hitting the trailing stop-loss.
They Can Lead to a Premature Exit
Trailing stop-loss orders can make your exit from a trade sooner than expected. This can happen when a price is only pulling back a little and not necessarily reversing.
One way to prevent this is to place trailing stops at a far distance from the prevailing price.
They Don’t Protect You From Large Market Moves
Trailing stops can’t protect you from significant market moves that are larger than your stop placement.
For instance, if your stop is set to prevent a 5% loss, but the market makes a sudden move against you by 20%, your stop becomes ineffective. This is because there’s no chance to trigger and fill your market order at the 5% loss point.
Author’s Recommendations: Top Trading and Investment Resources To Consider
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Conclusion
For any trader, the primary goal is to make profitable trades. Using trailing stop-loss orders, you can reduce your risks and also lock in gains as the price moves in your favor. What’s more, they work remarkably well in capturing large moves. However, a trailing stop loss can hamper your performance when the market is not making significant moves since small losses can erode your capital.
For best results, keep working on your trailing stop loss strategy to ensure its effectiveness and tracking your trailing stops to avoid flash crashes or other extreme trading situations.
BEFORE YOU GO: Don’t forget to check out my latest article – ‘Exploring Social Trading: Community, Profit, and Collaboration’. I surveyed 1500+ traders to identify the impact social trading can have on your trading performance, and shared all my findings in this article. No matter where you are in your trading journey today, I am confident that you will find this article helpful!
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