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In day trading, a trailing stop loss is a form of order that allows you to limit the maximum dollar amount or percentage of loss that you can sustain from a particular trade.
If the price of the underlying asset moves in your desired direction, the stop price will adjust accordingly. The stop will remain in effect even if the price of the security moves in the opposite direction of what you had anticipated.
Key Takeaways
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A trading order known as a trailing stop loss allows you to specify a maximum dollar amount or percentage of loss that you are willing to tolerate before the order is executed.
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When the market is moving in your favor, the stop price will move along with the market price; but, when the market is moving against you, the stop price will remain unchanged.
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This form of order is designed to shield you from suffering big losses while also securing gains for you.
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When the price of the underlying asset hits the stop price, the order transforms into a market order and is then carried out at the best available price.
Definition and Example of a Trailing Stop Loss
There is a type of order known as a trailing stop loss that is designed to assist you in locking in earnings while simultaneously protecting you from day trading losses. There is a limit placed on the amount that can be lost in the trade, but there is no limit placed on the potential profit that can be made if the trade goes in your favor. When the price of the underlying asset hits the stop price, this type of order automatically transforms into a market order.
Note
Due to the fact that your trade will be performed at the then-current market price, it is possible that it may be carried out at a price that is somewhat higher or lower than the stop price.
Trailing stops can be manually monitored and adjusted by traders, or they can be set up to run automatically with most trading systems and brokers. Traders also have the option of having trailing stops work automatically.
The Process Behind a Trailing Stop Loss
The initial placement of a trailing stop-loss order is performed in the same manner as the placement of a standard stop-loss order. For instance, a trailing stop would be a sell order that would be positioned at a price that is lower than the point at which the trade was initially entered if you were engaged in a long trade (selling an asset you already own).
The primary distinction between a traditional stop loss order and a trailing stop loss order is that the latter adjusts itself automatically whenever the market rises in your favor, whilst the former does not.
For instance, if the price increases by five cents, then the trailing stop would also increase by five cents in response to the change. If there was a 10 cent change in the price, the stop loss would likewise be adjusted upward by the same amount. However, even if the price started going down, the stop loss wouldn’t be moved at all.
Let’s say you want to start a long trade at $40, and you want to place a trailing stop loss of 10 cents at $39.90. In the event that the price reached $40.10, the trailing stop would be moved to $40 in response to the change. The trailing stop would be moved to $40.10 when the price reached $40.20.
If the price were to drop to $40.15 at that time, the trailing stop would not be moved; it would remain at $40.10. If the price were to continue falling and reach $40.10, the trailing stop-loss order would be converted into a market order, and you would be able to exit the trade at about $40.10, having protected approximately 10 cents of profit per share. If the price were to continue falling and reach $40.20, the trailing stop-loss order would not be converted into a market order.
| Long Trade Trailing Stop |
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The scenario for a short trade, in which you sell an asset that you have borrowed and then wait to buy it back at a lower price, is very similar to the scenario described above; however, because you anticipate that the price will go down, the trailing stop loss should be placed above the entry price. Imagine that you are going to engage in a short trade by selling shares that you have borrowed for $20 per share. If the price were to rise to $20.10 while you had a trailing stop-loss order in place, the order would be “stopped out” and you would incur a loss of 10 cents.
In the event that the price instead fell to $19.80, the stop loss would be adjusted downward to $19.90. Even if the price increased to $19.85, the stop loss would not be moved from its current location. In the event that the price dropped below $19.70, the stop loss would be adjusted downward to $19.80. Your order will be changed into a market order and you will exit the trade with a gain of approximately 20 cents per share if the price increases to $19.80 or higher.
Stop-loss order for short trades
What Individual Investors Should Understand About Trailing Stops
When using trailing stop-loss orders, one thing that you should be aware of is that they have the potential to get you out of a trade too early, such as when the price is merely pulling back a bit rather than actually reversing. Trailing stops should be placed at a distance from the present price that you do not expect to be reached unless there is a shift in the direction that the market is moving in. This will help you avoid the situation described above.
For instance, a market that typically shifts within a range of ten cents while continuing to move in the same general direction as the trend would require a trailing stop that is greater than ten cents, but not so great that the entire purpose of the trailing stop would be rendered moot if it was increased by that much.
Another concern is that trailing stops do not safeguard you against significant market shifts that are larger than the amount that you have your stop order set at. If you place a stop order with the intention of avoiding a loss of 5% but the market suddenly moves against you by 20%, the stop order won’t be of any use to you because there won’t have been a chance for your stop to have been triggered and your market order to have been filled near the point where you would have experienced a loss of 5%.
How to Set or Adjust a Stop Loss Position
The majority of brokers make available an option for trailing stop-loss orders. First, determine how much wiggle space you want to allow the deal (for example, 10 to 20 cents), and then review your order twice. It is now expected that your stop loss will adjust automatically in response to any changes in price.
Traders also have the option to manually trail their stop loss. They merely adjust the price of their stop loss in accordance with the movement of the price.
Different Strategies Besides Trailing Stop Losses
The trailing stop limit order is the primary choice that can be used in place of a trailing stop loss order. The only difference is that after the stop price is reached, the deal will be performed at the limit price you set—or a better price—rather than at the market price that was available at the time. This is the only difference.
