Trailing Stop Orders: How to Apply Trailing Stop in Trading

Trailing stops only move in one direction because they are designed to lock in profit or limit losses. If a 10% trailing stop loss is added to a long position, a sell trade will be issued if the price drops 10% from its peak price after purchase. The trailing stop only moves up once a new peak has been established. Once the trailing stop has moved up, it cannot move back down.

Understanding Trailing Stop Orders

A trailing stop order is a type of order that automatically adjusts the stop loss level as the market moves in your favor. This means that instead of setting a fixed price for your stop loss, you set a percentage or dollar amount away from the current market price. The key difference between a trailing stop order and a regular stop loss order is that the first one allows you to capture more gains if the market keeps moving in your favor

A trailing stop is a modification of a typical stop order that can be set at a defined percentage or dollar amount away from a security’s current market price. For a long position, an investor places a trailing stop loss below the current market price. For a short position, an investor places the trailing stop above the current market price. A trailing stop is designed to protect gains by enabling a trade to remain open and continue to profit as long as the price is moving in the investor’s favor. The order closes the trade if the price changes direction by a specified percentage or dollar amount. A trailing stop order is a type of stop order that moves with the market price to protect gains while allowing for potential additional profits. 

How Trailing Stop Works

Trailing stops can be either fixed or percentage-based:

1. Fixed Trailing Stop: You decide on a dollar amount to keep below the highest price the stock reaches. For example, you choose $5 

• Stock Price Goes Up: As the stock price goes higher, the trailing stop also moves up. So, if the stock hits $100, your trailing stop moves up to $95 (which is $5 below $100).
• Stock Price Falls: If the stock price then drops to $95, your trailing stop will sell the stock to lock in your profit.

In essence, a fixed trailing stop helps you secure profits by automatically selling the stock if it falls back by a set amount from its highest price.

2. Percentage-Based Trailing Stop: Here, the trailing stop is set as a percentage below the highest price achieved. For example, if you set a trailing stop at 5%.

• Set a Trailing Stop: You decide on a percentage to keep below the highest price the stock reaches. For example, you choose 5%.
• Stock Price Goes Up: If the stock price rises to $100, your trailing stop moves up to $95 (which is 5% below $100).
• Stock Price Drops: If the stock price then falls to $95, the trailing stop sells the stock to protect your gains.

In essence, the trailing stop follows the stock price up and will sell if the price drops by the set percentage from its highest point.

To better understand how a trailing stop works, consider a stock with the following data:

• Purchase price = $10
• Last price at the time of setting the trailing stop = $10.05
• Trailing amount = 20 cents
• Immediate effective stop-loss value = $9.85

If the market price climbs to $10.97, your trailing stop value will rise to $10.77. Even if the last price drops to $10.90, your stop value will stay at $10.77. However, should the price continue to drop to $10.76, it will break through your stop-level, triggering an immediate market order

Your order would be submitted based on the last price of $10.76. Assuming that the bib price was $10.75 at the time, the position would be closed at this point and price. The net gain would be $0.75 per share, less commissions, of course. During momentary price dips, it’s crucial to resist the impulse to reset your trailing stop, or else your effective stop-loss may end up lower than expected. By the same token, reining in a trailing stop-loss order is advisable when you see momentum peaking in the charts, especially when the stock is hitting a new high. Revisiting the aforementioned example, when the last price hits $10.80, a trader can tighten the trailing stop from $0.20 to $0.11, allowing for some flexibility in the stock’s price movement, while ensuring that the stop is triggered before a substantial pullback can occur. Shrewd traders maintain the option of closing a position at any time by submitting a sell order at the market.

Comparison with Other Stop Orders

Trailing stops differ from traditional stop-loss orders in their ability to adjust automatically. A standard stop-loss order remains static, meaning it only triggers when the price hits the stop level you initially set. In contrast, a trailing stop adjusts with the market price, offering more flexibility and potential for higher profits.

Setting Up a Trailing Stop Order

1. Choose the right broker

First, you need to choose a broker that allows trailing stop orders because not all brokers offer them. Different brokers have different rules. Some might charge a fee for using trailing stops or have limits on how small or large your order can be. Look at several brokers and see which ones fit your needs best before making a choice. Make sure your broker supports trailing stops and understand their fees and rules before you start using them.

2. Determine the stop loss level

 Decide on a price where you want to exit the trade if things go wrong. This helps limit your losses.  Set the stop loss price above the current market price. This means if the stock price falls to this level, your trade will automatically close to prevent further losses. 

Set the stop loss price above the current market price. If the stock price rises to this level, your trade will automatically close to limit losses. So you should put a stop loss level in a place that enables you to minimize your losses in the event the market turns against you.

3. Set the trailing stop distance

The trailing stop distance is the distance between the current market price and the stop loss level. It is important to set the trailing stop distance at a level that is appropriate for the volatility of the market. A trailing stop distance which is too close may cause the stop loss to execute, on the other hand, a trailing stop distance which is too large may lead to huge losses.

4. Monitor the trade

After placing the trailing stop order, you have to watch the trade carefully because sometimes the market can be very volatile and you may find yourself triggering the stop loss level before you even realize it. It is also important to adjust the trailing stop distance as the market moves in your favor. This can help to protect your profits while minimizing losses.

As the stock price goes up and you make more profit, you should adjust the trailing stop order distance. Changing the distance helps you protect the gains you’ve made. If the price starts to drop, the trailing stop will trigger a sell order at a higher price, helping you keep more of your profit while still limiting potential losses. Note that adjusting the trailing stop as the price rises helps you lock in profits and limit losses.

5. Consider other risk management strategies

Trailing stops help manage risk, but you should also use other strategies like diversifying your investments or hedging to protect yourself. Make sure your broker supports trailing stops and has good terms. Decide where you want to exit if the market goes against you. Change the distance as the price goes up to protect your profits. Keep an eye on your trade to make sure the trailing stop is working as planned. By using trailing stops along with other risk management methods, you can better protect your investments and improve your chances of success. 

Examples and Scenarios of trailing stop 

• Fixed Trailing Stop Example: Suppose you buy a stock at $50 and set a fixed trailing stop at $5. If the stock rises to $60, the trailing stop would adjust to $55. If the stock then drops to $55, your stop order would be triggered.
• Percentage-Based Trailing Stop Example: If you purchase a forex pair at 1.2000 and set a 2% trailing stop, the stop will be set at 1.1760 initially. If the pair rises to 1.2200, the stop would adjust to 1.1960. A subsequent drop to 1.1960 would trigger the stop.

The purpose of setting a trailing stop loss market order is to get at least some of the point if the price does not reach the take profit. For example, you open a long trade when the price rebounds from a support level. You place take profit at the resistance level and set stop price just below the support level.

Then the price can follow two possible scenarios:

Then the security price reaches take profit and automatically closes with a profit. The price does not not reach the exit price with take profit, reverses and declines.

The price falls and breaks out the support level and closes on a stop loss with a loss. The set trailing stop loss will rise after the price. Even if the price does not reach the take profit, the trailing stops will be located above the opening level of the transaction. As, the trade will be profitable.

Frequently asked Questions (FAQs)

1. How Does Trailing Stop-loss Works?

Set trailing stop losses on the chart just like you would for a regular stop in an open short or long position.

The scheme of the trailing stop loss operation:

• The point where a long trade opens. A black line denotes an upward price movement, and you draw a stop loss price trailing at a fixed distance below this line.
• Here, the price goes up. The trailing stop loss moves automatically behind it at a set distance. Then the local correction begins. The price drops slightly while the trailing stops at the same level.
• The price resumes its upward movement without touching the trailing stops. Otherwise, the system automatically closes the trade. The trailing stop continues to track the price upward after the user/system adjusts the distance stipulated in the market order parameters between the trailing stop and the price.
• The uptrend ends. During the last correction, the price dropped.
• The price touches the trailing stop. As a result, the transaction is closed automatically.
• The trader’s profit is the distance between the trade opening level (1) and the trailing trigger price (5).

2. What is a good trailing stop loss profit? 

The length of the trailing stop loss order depends on several parameters so there is no answer about its optimal length. Trading theory recommends that novice traders adhere to the classic rule 1:2 of 1:3 ratio between stop loss and take profit. Over time, you will figure out what ratio is optimal and how to calculate the length of the trailing.