Trailing Stop Loss Order - What is It?

Jakob Brezigar
Last updated: 12.June 2024
Reading time: 4 min

Welcome to the world of trading, where the only thing more volatile than the markets is the trader’s heartbeat during a price swing! If you’ve ever felt like a tightrope walker trying to balance your profits on the high wire of the stock market, then you, my friend, are in need of a safety net. Enter the hero of our story: the trailing stop loss order.

This nifty little tool is like having a financial guardian angel that automatically tightens the leash on your investments when the market starts acting like a wild beast. It’s your personal profit protector, ensuring that your gains don’t vanish faster than a magician’s rabbit. So, buckle up and let’s dive into the world of trailing stop losses, where we learn to let our profits run and cut our losses with the precision of a seasoned trader!

What is a trailing stop loss?

A trailing stop loss is an adjustable stop order that follows the market price of a security, maintaining a set distance, to protect gains or limit losses.

How does a trailing stop loss differ from a regular stop loss?

Unlike a regular stop loss, which remains fixed, a trailing stop loss moves with the market price, automatically adjusting to lock in profits or prevent excessive losses.

Can a trailing stop loss guarantee no losses?

No, a trailing stop loss doesn’t guarantee against losses. It limits potential losses or protects profits but can’t prevent all losses, especially in fast-moving markets.

Is a trailing stop loss suitable for all types of trading?

Trailing stop losses are versatile and can be used in various trading strategies, but they are particularly beneficial in volatile markets or for positions held over longer periods.

Key Takeaways - Trailing Stop Loss Order:

Trailing stop orders automatically adjust to market price changes, offering a dynamic approach to risk management and profit protection.
They are particularly effective in volatile markets, allowing traders to secure profits while providing a safety net against sudden downturns.
Trailing stop loss orders are versatile, applicable across various asset classes, and beneficial for both short-term traders and long-term investors.
Understanding market psychology is crucial for setting effective trailing stops, balancing risk and reward according to market trends and investor behavior.
Trailing stop orders automate the trading process, reducing emotional decision-making and enabling investors to manage risk more effectively.

What are Trailing Stop Loss Orders

Trailing stop orders are an indispensable tool for modern traders and investors, offering a sophisticated method for managing risk and securing profits in fluctuating markets. Unlike static stop-loss orders, trailing stop loss orders provide a dynamic approach, automatically adjusting to changes in the market price. This adaptability is crucial in volatile trading environments, where price movements can be unpredictable.

Trailing stop orders offer a blend of flexibility and security, allowing traders to protect their positions while capitalizing on market trends. They are particularly useful for those who prefer a set-and-forget strategy, as they automatically adjust without the need for constant monitoring.

Definition and Example of a Trailing Stop Loss

A trailing stop loss is a dynamic type of stop order that ‘trails’ the market price of a security. Set at a specific distance below the current market price for a long position (or above for a short position), this distance, often expressed as a percentage or dollar amount, adapts to changes in the market.

For instance, if an investor buys a stock at $100 and sets a trailing stop loss 10% below the market price, the stop loss order activates if the stock price drops to $90. However, if the stock price climbs to $120, the trailing stop loss adjusts to $108, maintaining the 10% gap. This example illustrates the trailing stop loss’s ability to protect gains while limiting downside risk, making it an attractive option for both conservative and aggressive traders.

Trading with Trailing Stop Orders

Trailing stop orders are a strategic choice for traders aiming to balance limiting losses and protecting gains. They shine in markets where price movements are unpredictable and swift. By automatically adjusting to the current market price, trailing stops help traders lock in profits while providing a safety net against sudden downturns. This feature is particularly beneficial in fast-paced trading scenarios like day trading or swing trading, where market conditions can change rapidly.

When to Use a Trailing Stop-Loss

Choosing to use a trailing stop loss depends on a trader’s risk tolerance and market outlook. These orders are ideal in scenarios where a trader expects a stock to perform well but wants to safeguard against unexpected downturns. They are also beneficial for those who cannot constantly monitor their investments, as trailing stops can act autonomously to protect against significant losses.

Additionally, trailing stop losses are useful in long-term investment strategies, where they can protect profits accumulated over extended periods without necessitating frequent adjustments.

How a Trailing Stop Loss Works

A trailing stop loss functions by setting a stop order at a predetermined distance from the market price. As the market price increases, the stop price rises proportionally, but if the market price falls, the stop loss price does not change. This mechanism ensures that the stop order is only triggered by a specified decrease in the stock price, effectively locking in profits while preventing large losses.

The trailing stop loss is a versatile tool that can be applied across various asset classes, including stocks, forex, and commodities, making it a universal solution for diverse trading strategies.

Example of a Trailing Stop

Consider an investor who purchases a stock at $50 and sets a trailing stop loss 5% below the market price. If the stock price rises to $60, the trailing stop would adjust to $57. However, if the stock price then falls to $57, the trailing stop order would be executed, limiting the investor’s loss while having allowed for the potential upside.

This example demonstrates the trailing stop loss’s effectiveness in adapting to market movements, providing a balance between risk management and profit maximization.

How to Place a Trailing Stop Order

Step 1 – Enter a Trailing Stop Sell Order

To place a trailing stop sell order, select the stock you wish to sell and choose the trailing stop order type. Set the trailing amount or percentage that aligns with your risk management strategy. This initial setup is crucial as it determines the level of protection and potential profit your position will have.

Step 2 – Order Transmitted

After placing the order, it is transmitted to the market. The initial stop price is set based on the current market price and your specified trailing amount. This step is automated, ensuring that the order reflects real-time market conditions and your specified parameters.

Step 3 – Market Price Rises

If the market price of your stock increases, the trailing stop price will also rise, maintaining the set distance from the market price. This upward adjustment is automatic, ensuring that your potential profits are protected as the stock price increases.

Step 4 – Market Price Falls

Should the market price fall, the trailing stop price remains static, acting as a buffer against significant losses. This feature is key to the trailing stop’s functionality, as it prevents the stop order from being triggered by normal market fluctuations.

Step 5 – Market Price Touches Stop Price, Market Order Submitted

When the market price reaches the trailing stop price, a market order is automatically submitted to sell the stock, thereby executing the trade. This final step ensures that your position is closed at a point that aligns with your risk tolerance, protecting you from further losses.

What Trailing Stops Mean for Individual Investors

For individual investors,trailing stops represent a method to automate risk management. By removing the emotional aspect of trading decisions, trailing stop orders help in securing profits and limiting losses. They are particularly useful for personal finance management, as they allow investors to participate in market gains while providing a safety net against downturns.

How Can Market Psychology Help Me With Trailing Stops?

Understanding market psychology is crucial in setting effective trailing stops. Recognizing patterns in investor behavior and market trends can inform decisions on setting trailing stops that are neither too tight (leading to premature exits) nor too loose (failing to adequately protect profits). This understanding can be particularly beneficial for active investors who seek to optimize their trade strategies in alignment with market sentiment and behavioral biases.

Why Should I Use a Trailing Stop?

Using a trailing stop is beneficial for several reasons. It allows for profit protection while limiting potential losses, adapts to changing market conditions, and provides a disciplined approach to risk management. Trailing stops are particularly advantageous in uncertain markets, where they can help investors navigate volatility with greater confidence.

The Bottom Line

Trailing stop orders are a vital tool for traders and investors, offering a balanced approach to securing gains and minimizing losses. By understanding and effectively using trailing stops, you can navigate market volatility with greater confidence and control over your investment outcomes. Their versatility and adaptability make them an essential component of a well-rounded trading strategy.

Disclaimer: The information provided in this article is for informational purposes only and does not constitute financial, investment, or other professional advice. All opinions expressed herein are solely those of the author and do not represent the views or opinions of any entity with which the author may be associated. Investing in financial markets involves risk, including the potential loss of principal. Readers should perform their own research and consult with a licensed financial advisor before making any investment decisions. Past performance is not indicative of future results.