What is a trailing stoploss?

A trailing stoploss is a type of order you can use while trading. It works like a traditional stop order, telling your broker to close your position if it reaches it certain amount of loss. However, a trailing stoploss can move, ‘trailing’ your position as it earns a return – hence the name.

This can make trailing stops powerful tools, even enabling you to lock in profits instead of only preventing losses. However, as a sophisticated risk management tool you should fully understand how they work before getting started.

Understanding trailing stoploss

A trailing stoploss is a type of stop order that moves with the market price of an asset. Unlike a traditional stop loss, which is set at a specific price level, a trailing stoploss order is set as a percentage or a fixed amount below the current market price.

As the market price of the asset rises, the trailing stoploss order also rises, maintaining a consistent gap between the stop loss and the market price.

The primary purpose of a trailing stoploss is to protect profits and limit potential losses. It allows investors to capture gains as the asset’s price increases, all while providing a safety net that automatically triggers a sale if the price starts to decline.

How trailingstop losses work

Trailing stoplosses work by following your position if it earns a profit, but locking in and staying put if it begins to reverse. So, if your market moves in your chosen direction, the stop will move in that direction too. But if sentiment switches and the market moves against you, the stop will still close your position.

You set a trailing stoploss a certain number of points away from the current market price. This is the maximum loss on your position (without slippage), and if the market moves this number of points against you the stop will execute, and your trade will close.

So far, this is exactly the same as a traditional stop. But the difference is if your market moves in your chosen direction instead.

Once it has moved up by the number of points you set, the stop will follow – initially to the level at which you opened your position, then again every time your market moves up by your set number of points.

Is a trailing stoploss a good idea?

Using a trailing stoploss can be a very good idea. As we’ve seen, they have some useful advantages over standard stops – chiefly that they allow for a passive risk management strategy that still reacts to price action.

However, trailing stops are only one tool in your risk management arsenal. And there are a few reasons why it doesn’t make sense to use them all the time.

How to use trailing stoploss effectively

Here are some guidelines on how to use trailing stoploss effectively in your trading strategy:

1. Determine Your tolerance: Before using a trailing stoploss, assess your risk tolerance and investment goals. Consider factors like your investment horizon, the volatility of the asset, and your overall portfolio diversification.
2. Set an appropriate trailing percentage or amount: Depending on your risk tolerance and market conditions, decide whether you want to use a trailing percentage (e.g., 10% below the market price) or a fixed dollar amount . Keep in mind that a larger trailing percentage provides more room for market fluctuations but may result in exiting positions too early.
3. Monitor and adjust: Regularly monitor your investments and adjust your trailing stoploss orders as needed. If the asset’s price continues to rise, consider trailing the stop loss to lock in more significant gains. Conversely, if market conditions change, you may need to tighten the trailing stoploss to protect your profits.
4. Avoid whipsaws: Be aware of potential whipsaws, which occur when the market briefly reverses before continuing in the original direction. To avoid being prematurely stopped out, consider setting a minimum price change requirement before the trailing stoploss is adjusted.
5. Combine with other strategies: Trailing stoploss orders work well when combined with other trading strategies and technical analysis tools. Consider using them alongside support and resistance levels, moving averages, or trend analysis to make more informed decisions.
6. Practice risk management: While trailing stoploss orders are effective tools, they are not foolproof. Always practice proper risk management by diversifying your portfolio, avoiding over-leverage, and sizing your positions appropriately.

Advantages of using trailing stoploss orders

Locking in profits: A trailing stoploss allows you to capture profits when the market price rises while preserving the opportunity for further gains. It acts as a safeguard to ensure you don’t lose too much if the market reverses.

Reducing emotional decision-making: Traders and investors often struggle with emotional decision-making. A trailing stoploss automates the process, reducing the need for impulsive actions based on fear or greed.

Flexibility: Trailing stoploss orders can be adjusted to match your risk tolerance and market conditions. You can set different trailing percentages or amounts depending on your investment strategy and objectives.

Protecting investment capital: By limiting potential losses, trailing stop loss orders help protect your investment capital, preserving it for future opportunities.

Disadvantages of the trailing stoploss

While trailing stops can be extremely useful, they do come with some downsides:

• You can ‘guarantee’ a standard stop loss to ensure that it won’t suffer slippage – when a market moves beyond your stop so quickly that it can’t be executed at your desired level – but not a trailing stop
• Trailing stops can encourage a ‘set and forget’ mindset, which is rarely recommended when trading active markets
• They can close positions early, instead of giving them room to breathe

All this means that you have to pay attention to when you should use a trailing stop, and when you do use one be careful about where to place it.

Conclusion

A trailing stop loss is a powerful tool for traders and investors looking to manage risk and protect their gains in the financial markets. It provides flexibility, automates the decision-making process, and allows you to capture profits while limiting potential losses.

To use it effectively, assess your risk tolerance, set appropriate trailing parameters, and regularly monitor and adjust your orders based on market conditions. When used in conjunction with other trading strategies and risk management techniques, trailing stop loss orders can contribute significantly to your overall trading success.