Trailing Stop Loss: How To Limit Your Trading Losses

What is a Trailing Stop Loss?

A trailing stop loss is a type of stop loss order designed to protect your gains and limit your losses.

Unlike a traditional stop loss, which remains fixed at a specific price level, a trailing stop loss adjusts itself as the market price of your asset moves.

This dynamic stop loss moves in the direction of your trade by a set percentage or dollar amount, allowing you to capture more profit while still having a safety net if the market turns against you.

Trailing Stop-Loss Example

Let's consider a practical trailing stop order example to illustrate how a trailing stop loss works:

• You buy a stock at $100 and set a 10% trailing stop loss.

• The stock price increases to $130. Your trailing stop loss adjusts to $117 (10% below $130).

• The stock then decreases to $115. Since this price is below your trailing stop loss level of $117, the stop loss order is triggered, and your position is sold at the market price, locking in a profit of $17 per share.

Different Types of Trailing Stop Loss

There are different types of trailing stop loss, such as percentage-based, dollar-based, volatility-based, and time-based trailing stop loss.

Percentage-Based Trailing Stop Loss

A percentage-based trailing stop loss adjusts the stop loss level based on a fixed percentage of the current market price.

For example, if you set a 10% trailing stop loss on a stock trading at $100, the stop loss level will be set at $90. As the stock price rises to $110, the stop loss level will move to $99, maintaining the 10% distance.

This type is useful for traders who want a consistent buffer relative to the asset's price.

Dollar-Based Trailing Stop Loss

A dollar-based trailing stop loss sets the stop loss level based on a fixed dollar amount below (or above, for short positions) the current market price.

If you set a $10 trailing stop loss on a stock priced at $100, the initial stop loss level is $90. As the stock price rises to $120, the stop loss level moves to $110, maintaining the $10 distance.

This approach is straightforward and provides a fixed monetary threshold for risk management.

Volatility-Based Trailing Stop Loss

A volatility-based trailing stop loss adjusts according to the asset's volatility, using indicators like the Average True Range (ATR) to determine the trailing amount.

This type of trailing stop loss is useful for assets with varying volatility, as it adapts to changing market conditions. By considering market volatility it helps to avoid being stopped out by normal price fluctuations, offering a more dynamic risk management strategy.

Time-Based Trailing Stop Loss

A time-based trailing stop loss adjusts the stop loss level at regular time intervals.

For example, you can set the stop loss to move up by a certain amount every day or week, regardless of the price movement.

This type of stop loss is less common but can be useful in specific trading strategies where time-based adjustments are preferred. It provides a unique approach to managing trades over specific periods.

Each type of trailing stop loss offers different advantages and can be selected based on the trader's strategy, risk tolerance, and the nature of the traded asset.

How Does a Trailing Stop Work?

Here’s a detailed breakdown of how a trailing stop loss operates:

1. Setting the Trailing Amount: The first step in using a trailing stop loss is to decide on the trailing amount. This can be a fixed dollar amount or a percentage of the market price.
   For instance, if you choose a 10% trailing stop loss on a stock priced at $100, your initial stop loss would be set at $90.

2. Order Placement: You place the trailing stop loss order with your broker. As the price of the stock increases, the trailing stop loss adjusts accordingly.
   If the stock price rises to $120, your trailing stop loss will move to $108 (10% below $120).

3. Price Movement: As long as the market price keeps rising, the trailing stop loss follows it. However, if the market price starts to fall, the stop loss level remains at its highest adjusted point.

4. Execution: If the stock price drops to the trailing stop loss level, the order is executed, selling your position at the current market price, thus locking in your gains and limiting further losses.

How to Set a Trailing Stop Loss: Step-by-Step Guide

Setting up a trailing stop is relatively simple, but the exact process may vary depending on your trading platform. 

Here's how to set a trailing stop loss: 

1. Open the Trade Ticket

2. Select ‘Trailing Stop’ Option

3. Set Your Stop Distance

4. Choose the Trailing Step

5. Review and Place the Order

6. Monitor the Trade

Let’s go through this step by step. 

1. Open the Trade Ticket

Log into your trading platform and navigate to the asset you want to trade. Open the trade ticket, which is where you'll place your buy or sell order.

2. Select ‘Trailing Stop’ Option

In the trade ticket, look for the ‘Stop’ options. You’ll typically find choices like 'Standard Stop,' 'Limit Stop,' or 'Trailing Stop.' Choose the ‘Trailing Stop’ option from the dropdown menu.

3. Set Your Stop Distance

Decide how far away from the current market price you want your trailing stop to be. You can set this as either a fixed dollar amount or a percentage. For example, if you choose a 5% trailing stop on a stock priced at $100, the initial stop will be set at $95.

4. Choose the Trailing Step

Some platforms allow you to specify a ‘trailing step’—the minimum amount the market must move in your favor before your stop adjusts. For example, if you set a trailing step of $1, the stop will move up only when the stock’s price increases by $1 or more.

5. Review and Place the Order

Double-check all the details of your order, including the trailing stop distance and trailing step (if applicable). Once you're satisfied, place the order.

6. Monitor the Trade

While trailing stops automate the process of adjusting stop-loss levels, it's still a good idea to monitor your trades, especially in highly volatile markets. This way, you can make adjustments if market conditions change drastically.

Advanced Trailing Stop Strategies

Using trailing stop orders is a practical approach to risk management and profit protection. They are particularly beneficial in volatile markets where prices can swing significantly quickly.

By automatically adjusting to favorable price movements, trailing stop losses allow traders to stay in profitable trades longer while providing a safety net against sudden reversals.

Below are some of the cases where one should consider adopting trailing stop loss.

Trading Strategy for Market Trends

One of the most effective times to use a trailing stop loss is during strong market trends. In a trending market, prices tend to move steadily in one direction—upwards in a bull market or downwards in a bear market.

A trailing stop helps you capture the majority of these movements. As the price trends in your favor, the trailing stop loss moves with it, ensuring you lock in profits.

For instance, if you buy a stock at $50 and it trends upwards to $80, a trailing stop loss set at 10% would move from $45 initially to $72, securing a significant portion of your gains.

Trading Strategy for Volatile Assets

Trailing stop losses are particularly useful for managing trades involving highly volatile assets. Volatile assets can experience sharp price swings within short periods, making it challenging to manage risk using static stop-loss orders.

For example, in the forex market, where currency pairs can exhibit high volatility, a forex trailing stop loss can prevent substantial losses while allowing for potential gains.

To benefit from trailing stop losses in this case, follow the below steps:

1. Identify highly volatile assets, such as major forex pairs. 

2. Enter a trade when volatility provides a potential breakout signal. For instance, enter a long trade when a forex pair breaks above a key resistance level.

3. Set a wider trailing stop (e.g., 20-30 pips in forex trading) to avoid being stopped out by normal market noise. For example, if you go long on EUR/USD at 1.1500 with a 30-pip trailing stop, your initial stop is at 1.1470.

As the price moves in your favor, the trailing stop adjusts accordingly. In volatile markets, this allows you to capture gains without being stopped out too early.

Trading Strategy for Long-Term Trades

For traders engaging in long-term trades, a trailing stop loss offers a way to lock in gains over extended periods.

As the price of an asset appreciates over time, the trailing stop loss moves up, ensuring you don’t give up accumulated profits if the market experiences a downturn.

To use trailing stop-losses in your long-term trades:

1. Enter a trade based on long-term analysis, such as fundamental research or technical analysis of the asset’s long-term chart.

2. Since you’re holding for the long term, set a relatively wide trailing stop, such as 20% below the current price. This allows the asset to experience normal market corrections without triggering an unnecessary sell-off. 

3. Check the trailing stop level every few months and adjust if needed. As the asset price appreciates, the trailing stop will gradually move up, protecting more of your gains.

This is especially beneficial for investments in growth stocks or other long-term financial instruments. By setting a trailing stop loss, you can participate in long-term upward trends while minimizing the risk of significant drawdowns.

Trailing Stop Loss in Swing Trading

Swing trading is a strategy that involves holding positions for a few days to several weeks to capitalize on short- to medium-term price movements. 

Swing traders use trailing stops to lock in gains while giving trades room to move. Here’s how to apply a trailing stop loss in this strategy:

1. Set a tight trailing stop loss, such as %5 below the current price. This approach helps protect profits in case the market reverses quickly.

2. Use technical indicators like RSI, moving averages, or support and resistance levels to identify potential swing points. Enter a trade when the market shows signs of a potential upward or downward swing.

3. As the price moves in your favor, the trailing stop will automatically adjust, maintaining the set distance (e.g., 5%) from the highest price. 

For instance, if you buy a stock at $50 and it moves up to $60, your trailing stop will follow to $57 (5% below $60).

This ensures that if the market turns against you, you exit the trade with a secured gain.

Trailing Stop Loss in Momentum Trading

Momentum trading involves entering trades based on the strength and direction of current price movements. The idea is to "ride the wave" of a strong trend until signs of a reversal appear.

In momentum trading, trailing stops help you capture rapid gains while providing a buffer against sudden reversals. 

Here’s how to implement this strategy:

• Set a trailing stop aligned with momentum: Since momentum trading involves fast, directional movements, a slightly wider trailing stop (8-10%) is often used. 

• This gives the trade enough breathing room to continue moving in the desired direction without being stopped out prematurely by minor market fluctuations.

• Enter a trade when momentum indicators like MACD confirm a strong directional movement. 

Suppose you buy a cryptocurrency at $1,000 and set a 10% trailing stop. 

As the price surges to $1,500, your trailing stop adjusts to $1,350. If the momentum shifts and the price drops to $1,350, your position is automatically sold, locking in a $350 gain. 

This approach allows you to capture most of the upward movement while protecting your profits from sudden market reversals.

Advantages and Disadvantages of Trailing Stop Loss

Trailing stop loss can be beneficial to a lot of traders, but it also has some drawbacks.

Advantages

• Maximizes Profits: Allows you to capture more gains by moving with the market price.

• Limits Losses: Predetermines the maximum loss you’re willing to take on a trade.

• Automation: Reduces the need for constant market monitoring.

• Flexibility: Can be tailored to different trading strategies and risk tolerances.

Disadvantages

• Whipsaw Risk: In highly volatile markets, the trailing stop can be triggered by short-term price fluctuations, resulting in premature exits.

• Market Gaps: If the market price gaps down or up significantly, the trailing stop may not execute at the expected price.

• Over-reliance: Relying solely on trailing stop losses without other risk management strategies can be risky.

Conclusion

Trailing stop losses are very important for traders as they offer a blend of risk management and profit protection.

By effectively using a trailing stop loss, you can enhance your trading strategy, minimize losses, and secure your gains.

Remember to tailor your trailing stop loss settings to your trading style and market conditions for the best results.