Last Updated on 17 November, 2020 by Therobusttrader
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 trade management techniques. But what does trailing stop mean?
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, so they are also known as protective stops.
There is a lot to learn about this trade management technique and how to use it in your trades. 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?
A trailing stop functions as a stop loss order, but instead of staying at a fixed point, it moves with the price as long as the price is moving in a favorable direction. To understand how the trailing stop works, we need to understand how a trade is closed and how the stop loss order works.
Closing a trade requires an equal but opposite order. In other words, 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.
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.
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 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). 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). In the image below we demonstrate how this works when using plain stop losses (non-trailing)
Getting to the Trailing Stop
Bringing this to trailing stop, a trailing stop works like a regular stop loss order in that it closes the trade 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 when the price is moving in the direction of the trade.
So in a long trade, the trailing stop moves upwards, 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.
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 market moves against you.
Before we go on to how we best use a trailing stop loss, let’s have a look at some of the benefits of using them!
The Benefits of Trailing Stop Losses
A trailing stop can be of great benefit to a 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. The following are some of the common benefits of using a trailing stop.
1. Managing risks
Being like a stop loss, a trailing stop can be used to prevent huge losses when trading. 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, so the trailing stop can start protecting the trade from the very beginning.
This way, it can help limit 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.
Let’s visualize this to make it easier to understand. In the image 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.
2. Protecting Profit
Some traders 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. Like in the image below:
If a 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 trade will be automatically closed when the price gets to the stop loss level, and 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 trader 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.
3. Letting Winners Run
One of the main benefits of a trailing stop is that it helps a trader to ride the winners. 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.
For such 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.
4. Flexibility in Managing Trades
A major advantage of a trailing stop is the flexibility it affords a trader 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 put in his preferred settings, the script implements the instructions without the trader’s presence.
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!
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.
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.
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 could work well with mean reversion as well, it’s just that we have not seen that to any larger extent in our testing!
Let’s now cover the most important thing you need to keep in mind when using trailing stop losses!
Where You Should Set a Trailing Stop
When using a trailing stop, it is very important to set it at the right level. 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, a 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 trail by a percentage of the price movement.
To choose the right percentage level for your trailing stop, you 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.
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.
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.
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.
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.
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.
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. When the price crossed the lower boundary, the trade was closed.
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.
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 it, 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.