Last Updated on 11 September, 2023 by Samuelsson
Knowing how important it is to manage risk when you enter a trade and also protect your profit when the trade is moving in your favor, you may want to consider adding a trailing stop to your long position trade management techniques. But what does trailing stop mean? A trailing stop means setting a stock loss order that moves with the markets to automatically close out your position if the price falls beyond a certain level.
A trailing stop is an opposing stop order that can be set to automatically follow the price — at a specified dollar amount, percentage of price, or any other preset distance away from the current price — when the price is progressing in the direction of the trade. Trailing stops are used to protect profits and minimize stock loss, so they are also known as protective stops. This strategy is commonly used for long positions to reduce risk and lock in gains during a term trend. Additionally, traders can use loss orders to limit potential losses and manage their risk more effectively.
There is a lot of insights to gain about this trade management technique, specifically for long positions, and how to use it in your trades. Pro tip: consider implementing a trailing stop as a stock loss strategy. Keep reading to get a deep understanding of trailing stops.
If you’d like to learn more about stop losses in general, then you should have a look at our complete guide to stop losses!
What Is a Trailing Stop?
Trailing Stop Loss
A trailing stop functions as a stop loss order in the stock market, but instead of staying at a fixed point, it moves with the price trend as long as the trend is favorable. To understand how the trailing stop works, we need to understand how a trade is closed and how the stop loss orders work in achieving the target.
Closing a trade requires an equal but opposite order. In addition, traders may choose to use stop loss orders or trailing stop loss to automatically close their positions if the market moves against them. Alternatively, they can use stop limit orders or trailing stop limit to set specific price levels at which their positions will be closed. To close a long position, the trader must place an equal sell order in the market.
To manage the risk of adverse price movement, a trader normally places a stop loss order when entering a trade. The stop loss order is nothing but a stop order — in the opposite direction to trade entry — placed at a fixed distance away from the price level where the trade was entered. This helps to limit losses and protect the trader’s position. Additionally, traders may also consider using trailing stop orders, which can automatically adjust the stop level as the stock price moves in their favor, allowing them to lock in profits. Trailing stops are typically set at a certain number of cents or percentage points away from the current stock price.
The Stop Order and Its Placement
A stop order is an order to buy or sell a security when the price reaches the specified price level, known as the stop price. When the price reaches the stop price, the stop order becomes a normal market order. A stop order is usually placed ahead of the price in the intended direction. So a sell stop order is placed below the current price level, while a buy stop order is placed above the current price. Trailing stock can be used to follow a long-term trend and protect a position from sudden drops by setting a stop loss at a certain number of cents below the trailing stock price.
Now, you can see that a stop loss order can be either a buy stop order or a sell stop order, depending on the direction of trade in the stock market. In other words, for a trader who is in a long position, the stop loss order will be a sell stop order (to sell back the security when the price reaches the stop price) to avoid losses. On the other hand, the stop loss order for a short position will be a buy stop order (to buy back the security when price reaches the stop price) to minimize risks. It is important to note that stop loss orders should be aligned with your subscriptions and term trend viewpoints to ensure profitability. In the image below we demonstrate how this works when using plain stop losses (non-trailing).
Getting to the Trailing Stop
Bringing this to stock trailing stop, a trailing stop works like a regular stop loss order in that it closes the position when there is a significant adverse price movement. However, a trailing stop has the characteristic feature of being able to automatically move with the price trend when the price is moving in the direction of the trade. This is particularly useful for subscribers who want to manage their trades more efficiently.
So in a long stock trade position, the trailing stop moves upwards with the trend, at a certain distance below the price, when the price is going up. This distance can be calculated in a number of ways, and is something we are going to have a closer look at soon! For example, you could use a moving average, ATR, or just set the trailing stop loss level at a certain dollar amount from the last close. Don’t forget to subscribe to our newsletter for more trading tips and strategies!
Depending on the type of trailing stop you use, the trailing stop doesn’t have to move when the price is moving against the direction of the trade. For instance, if you use a fixed percentage trailing stop, meaning that you calculate the distance to the stop loss like a percentage away from the highest close ( if in a long trade), then this will be the case. Then the stop level will move up with the price, but not change when the price moves against you. This type of trailing stops, and many more, will be covered in greater detail in a moment!
On the other hand, trailing stops like moving averages will continuously adjust themselves, also when the stock price moves against you. This is especially important for subscribers of fidelity who need to keep track of the last price to make informed decisions.
Before we go on to how we best use a trailing stop loss in the stock market, let’s have a look at some of the benefits of using them! Trailing stop loss subscriptions can help you stay up-to-date with the last price movements of your fidelity investments.
The Benefits of Trailing Stop Losses
A trailing stop can be of great benefit to a stock trader when it is used in the right way. It can be a useful risk management and trade management tool, helping a trader to control losses and secure profits. Fidelity subscribers can take advantage of this feature and receive email notifications when their trailing stops are triggered.
1. Managing risks
Being like a stop loss, a trailing stop can be used to prevent huge losses when trading stock. Even though it may be placed at any time after a trade has been placed, a trader can place a trailing stop at the same time he places a trade with Fidelity, so the trailing stop can start protecting the trade from the very beginning. The trailing stop will automatically adjust to changes in the market price, making it a useful tool for those with subscriptions to real-time market data.
This way, it can help limit stock losses if the trade does not move in the trader’s favor. In this situation, the trailing stop starts trailing from a negative profit. As the price moves in the trader’s favor, the trailing moves closer to the entry-level (breakeven level), reducing the size of the potential loss if price moves adversely. If you have any questions, please email fidelity with your last name included.
Let’s visualize this to make it easier to understand the stock market. In the email below, you see how we entered a trade with our trailing stop loss in place. If the trailing stop had been hit before the market had advanced in our direction, then we would have incurred a loss with Fidelity. The characters in the market can be unpredictable, so it’s important to have a solid strategy in place.
Trailing Stop Loss
2. Protecting Profit
Some stock traders at Fidelity only use a trailing stop when the price has been moving favorably and the trade is already in profit. Before then, they use a fixed stop loss order to limit the downside risk. In this case, the trailing stop helps to protect the realized profits and prevent an already profitable trade from ending in a loss if the price changes direction without reaching the intended profit target. They may also receive an email notification when their trailing stop is triggered.
Protective Trailing stop
If a stock trade is left with just the fixed stop loss and the stop loss doesn’t move to a level where it can protect realized profits, the fidelity trader will receive an email notification before the trade is automatically closed when the price gets to the stop loss level. The trader will end up with a loss, despite the initial profits. That is, of course, if the exit condition is not met before!
For example, say a trader buys a stock at $75 and sets a stop loss order at $70 and a profit target at $85. Assuming the price moves up to $84.3, couldn’t get to the target, and drops to $68, the trade would have been stopped out at $70 with a loss — even though it had gained over 90% of the intended profit.
But if the stock trader at Fidelity was using a trailing stop, say trailing at $3 away from the current price, the trailing stop would have been at $81.3 when the price reversed. So he would have locked-in $6.3 profit, rather than ending up with a loss. The trader could have received an email notification when the price hit the trailing stop of $81.3, allowing him to make a quick decision in just a few characters.
3. Letting Winners Run
One of the main benefits of a trailing stop is that it helps a stock trader, like those using Fidelity, to ride the winners by adjusting the stop loss based on the market price. In trading, one of the most popular maxims is, “Cut the losses and let the winners run.” A trader, who is using a trend-following strategy, can afford to ride the trend with the help of a trailing stop that adjusts based on market price.
For such stock runner trades, the trader doesn’t have a profit target, and the upside is potentially ‘unlimited’. With a trailing stop, the trader can automatically lock-in the gained profits while he aims to milk the trend for as long as it lasts. The loss level can be set at a market price, ensuring fidelity to the strategy.
4. Flexibility in Managing Trades
A major advantage of a trailing stop for stock traders is the flexibility it affords in managing a trade. It automatically tracks the security’s price direction, so the trader does not need to manually reset the stop loss order when the trade is moving in his favor. Once the trader sets up their preferred settings, the script implements the instructions without the trader’s presence. This feature is particularly useful for Fidelity clients who want to manage their trades remotely and receive alerts via email. Additionally, trailing stops can be customized with specific characters to differentiate them from other types of orders.
With a trailing stop, trade management might become easier, and the trader doesn’t need to keep monitoring all the time. Moreover, it helps to remove emotions from the trade management decisions, so beginner traders who do not have enough discipline can use it to practice a hands-off approach to trading. In fact, it’s reminiscent of algorithmic trading, in that respect!
Related reading: Maximum Adverse Excursion
When to Use a Trailing Stop Loss
Although a trailing stop can help a trader to lock-in profits and makes trade management easy, it may not be helpful at all times. Deciding when to use a trailing stop depends on the trader’s trading experience, trading style, and the situation in the market. It is also important to keep in mind that some brokerage firms like Fidelity may have specific requirements for using trailing stops, which can be found in their email communications or by checking their website. Additionally, it is recommended to avoid using trailing stops with last name characters that are difficult to pronounce or remember, as this can lead to confusion and potential errors in trade execution.
As always, you should try to backtest your strategy in order to find out what works best. However, there are some things that can be said about trailing stop losses in general.
Since a trailing stop loss is designed to let the winners run, and cut off a trade when the market reverts, trailing stop losses usually work better with trend following strategies. In fact, in theory, a stop level that moves with the market trend and gets you out of the trend when the market reverts, is perfect. However, as we will see soon, there are some dangers that you will have to deal with to get optimal results.
Riding the Trend
What About Mean Reversion?
Traders who trade mean reversion strategies usually don’t implement trailing stop losses. The main reason for this is that a mean reversion edge gets better the more a security has gone down. Therefore, it is hard to place a trailing stop that will lock in profits, since it will become so wide that it fails to serve that purpose. Mean reversion trades require very wide stops not to interfere too much with the trading strategy.
However, it is very possible that trailing stops, when set at a specific percentage below the market price, could work well with mean reversion as well, it’s just that we have not seen that to any larger extent in our testing! If you’re interested in learning more about this strategy, feel free to reach out to us via email. Also, please note that the effectiveness of trailing stops may vary depending on the last name of the trader.
Let’s now cover the most important thing you need to keep in mind when using trailing stop losses! It is crucial to consider the current market price when setting your stop loss. Also, make sure to enter your last name and email address correctly when placing your trade to receive notifications on any price movements.
Where You Should Set a Trailing Stop
When using a trailing stop, it is very important to set it at the right level and be notified through email. This means setting it at a level that is not too close to the current price level and not too far either. If the trailing stop is placed too close to the current price, it will not allow enough room for the normal price gyrations, and the trade could be closed prematurely before any meaningful move could occur.
On the other hand, if a trailing stop is too far away from the current price, it will mean giving back more profits than is necessary to find out if a trend has reversed. So the best thing is to find an appropriate middle ground, but getting the ideal trailing distance is not always easy, as the market condition is always changing.
However, a trader can gauge the right distance from the historical price movements, through backtesting. The aim is to set the trailing stop at a distance from the current price where it is not expected to be triggered unless the price has changed direction. So if the normal pullbacks in a market are about $10 or less, a trailing stop that is more than $10 is necessary, but it shouldn’t be too far from that so as not to give back much of the profits.
As a rule, an email trailing stop is meant to close a trade only when it is very likely that the price is reversing.
A Practical Example of Trailing stop
Let’s say you bought 100 shares of Facebook Inc. at $100. Checking the Facebook price chart, you saw that the stock is trending up and that, historically, the price usually pullback about 4% to 10% before continuing to move up again. You can decide to use a trailing stop loss or trailing stop limit to set a stop loss level for your investment. This will help you avoid significant losses by automatically selling your shares if the price falls below a certain level. Another option is to use stop loss orders to protect your investment in case of a sudden price drop.
To choose the right percentage level for your trailing stop, you can receive an email notification when the price reaches a certain level. Find a level that is neither too tight nor too wide. Since the historical pullbacks are in the region of 4-10 percent, if you use any value that is less than 10%, it may be too close, and a normal pullback can get to the stop price, closing your trade before the expected price move occurs.
On the other hand, if you choose to trail at 30% of the current price, it may be too wide — meaning that you will be giving back too much of your profits unnecessarily. A better choice may be to set your trailing stop at 12% or 13%. This way, your trade has room to move, and in the event that the price changes direction, your trade will be closed without losing too much of what has been gained. Since a typical pullback is less than 12%, when the price drops by more than 12%, it means that the trend might be changing direction. Don’t forget to set up an email alert for when your trailing stop is triggered.
With a 12% trailing stop, the trailing stop will be at $88 at the time you entered the trade, assuming you placed it immediately. When the price rises from $100 to $150, the trailing stop will be at $132, and when the price gets to $200, your stop will be at $176. If the price starts dropping from $200, your stop will remain at $176, and if the price falls to that level, your shares will be sold. Don’t forget to set up an email notification for when your shares are sold.
Trailing Stop vs Normal Stop Loss
The main difference between a trailing stop and a normal stop loss order is that the former automatically follows the price movement when the price is progressing in the direction of the trade. A normal stop loss stays at the same level where it was placed unless it is manually moved by the trader. If you want to receive an email notification when your trailing stop is triggered, some trading platforms offer this feature.
While it is easier to use a trailing stop to lock-in profits, a normal stop can also be used to trail the price. It only requires the trader to regularly move the stop loss to a new level, based on how the price has moved and the trailing method. If you would like to receive updates on when to move your stop loss via email, you can set up email alerts through your trading platform.
Different Methods of Trailing Price
There are many different ways of trailing price, and each one will change how the trailing stop adapts to the movements of the market. Therefore, one method might have a significant advantage over another. However, this tends to vary by trading strategy and market, so you will once again have to test yourself, through backtesting. If you need further assistance, feel free to send us an email.
Let’s look at some of the ways you can calculate the distance to the trailing stop!
1.Absolute dollar amount
Trailing by absolute dollar amount is one of the most common methods of trailing price on most charting platforms, and it works in a very simple way. It only requires you to set the right dollar amount, like $10, and the script trails the price at that price distance until the trade is stopped out.
For example, if you start trailing at $100, your stop will be at $90. When the price moves up to $150, your stop will be dragged to $140 ($10 away from the current price).
2. Percentage of price
Another simple method of trailing price is by using a certain percentage of the current price. Many charting platforms have scripts that calculate the price value and drag the stop order accordingly. All you need to do is to set your chosen percentage, say 10%.
So if you are starting from $100, your trailing stop will initially be at $90, but when the price moves to $150, your stop will be dragged to $135 (10% of the current price away from the current price).
3. Moving average
Some traders trail price using the moving average method. It can be done manually by regularly dragging the stop loss order to the level of a chosen moving average indicator. But there are scripts that automatically trail the price based on the chosen moving average.
Moving Average Trailing Stop
From the chart above, you can see where the trade was entered and how the moving average followed the price. When the price eventually hit the moving average, the stop was triggered, closing the trade.
4. Donchian Channel
The Donchian Channel is another indicator that traders can use to trail price. A trader can choose a setting of his choice and manually drag his stop loss order the indicator level from time to time. However, there are available scripts that can trail the price in accordance with the Donchian Channel.
In the image above, you can see where the trade was entered and how the Donchian Channel followed the price with a trailing stop loss. When the price crossed the lower boundary and hit the stop loss level, the trade was closed using stop loss orders.
5. Average True Range
The average true range (ATR) is a very important indicator that is used to measures volatility in the market. Because it can adapt to the changes in market volatility, programmers have created many ATR-based indicators for trailing the price. One of those ATR-based indicators is the Chandelier Exit, which uses a 22-period ATR to identify out-sized price movements. There are scripts that automatically trail the price in accordance with the Chandelier Exit.
Trailing Stop ATR
From the above image, you can see where we entered a trade and how the Chandelier Exit was closely trailing the price until it broke below the stop loss level, closing the trade.
Trailing stop order vs. a Trailing stop Limit Order
A trailing stop limit order is very similar to a trailing stop order in that both trail the price movement, but while a trailing stop order sends a market order when the stop price is hit, a trailing stop limit order sends a limit order when the stop price is hit.
When a stop order is triggered, the order is filled at the best available price in the market, meaning that the order could be filled at a price level that is very different from where the order was triggered — slippage. In a stop limit order, there is a limit price for filling the order — there’s a maximum allowable slippage.
So unlike the stop order, where only the stop price is specified, in a stop limit order, two levels must be specified — the stop price, where the order is triggered, and the limit price, beyond which the order cannot be filled. For instance, a security trading at $100 can have a stop limit order of 10% stop price and $2 limit price. This will translate to a stop price of $90 and a limit price of $88. In this case, the sell order can only be filled between $88 and $90.
Here you can read more about choosing between a trailing stop order vs. a trailing stop limit order.
A trailing stop is a stop order that can be set to automatically follow the price, at a specified dollar amount, percentage of price, or any other preset distance away from the current price, when the price is progressing in the direction of the trade. Trailing stops are used to manage risks, protect profits, and ride a trend.