The primary objective in trading is to generate profits, and traders strive to minimize losses caused by market volatility. Various order types serve as risk management tools, often enabling traders to buy or sell an asset at a more favorable price than the current market price, thereby seizing opportunities that might otherwise be missed.
Over decades of active stock trading, traders have developed numerous strategies and tools. This article focuses on the trailing stop order, providing a clear definition, explaining its application, illustrating its use with examples, and addressing key questions surrounding this valuable order type.
What Is a Trailing Stop?
A trailing stop order is a specialized form of a stop order that is set at a predetermined percentage or fixed amount away from the market price of the asset being traded. Buyers place trailing stop-loss orders below the current market price, while sellers position them above.
Image source: LifeFinance
This order type helps traders avoid missing out on additional profits if the price continues to move favorably after reaching a desired level. The order is executed only when the price changes direction by the preset percentage or amount. This mechanism allows traders to potentially achieve higher profits.
Trailing stop orders are placed in conjunction with a regular trading order, either simultaneously or slightly later, to mitigate potential losses and maximize gains. To effectively use trailing stop orders, investors need to understand how to set the “trail level” – the specific asset price or percentage that triggers the order. Deciding between a percentage-based or price-based trail is another crucial consideration.
Trailing stop orders move in a single, predetermined direction. Their core function is to secure profits or minimize losses. For example, if a 10% trailing stop-loss order is added to a buy order, a short trade is initiated if the asset price falls 10% below its peak price after the purchase. The trailing stop order will then move upwards only after a new peak is reached. It cannot reverse and move downwards once it has begun to move upwards.
Trailing stop orders offer a significant advantage over standard stop-loss orders by providing greater flexibility. They automatically track the price direction of the asset, eliminating the need for manual adjustments that are required with traditional stop-loss orders.
Trading with Trailing Stop
To utilize trailing stop orders effectively, investors need to carefully determine the appropriate price or percentage interval. Setting the order too tight can lead to premature triggering by minor market fluctuations, leaving insufficient room for the trade to move favorably. This can result in minimal extra profit or even a complete loss on the trade.
Conversely, setting an excessively wide order may make it insensitive to small market movements, but it significantly increases the risk of substantial losses. Furthermore, it may lead to missed opportunities for greater profits.
Image source: Novel Investor
Finding the optimal percentage or price distance for a trailing stop order is a challenging task. Market behavior is inherently dynamic, and traders must consider the specific characteristics of the current market movements and the asset being traded. A correctly set trailing stop order can, however, yield significant rewards.
However, a distance that proves successful in one instance may not be as effective in another. This inherent variability is a key challenge when using trailing stops. Traders need to recalculate the optimal settings for each new trade. Fortunately, there are some helpful guidelines for adjusting the trailing distance in response to changing market conditions.
In a calm market, or when trading a relatively stable asset, a tighter distance is generally recommended. A common mistake traders make is known as “loss aversion.” This involves increasing risk during a trade in an attempt to avoid losses, often leading to further losses.
Trading With Trailing Stop Limit
A trailing stop limit order acts as a risk management tool by allowing traders to set a limit on potential losses while preserving the potential for maximum returns.
A sell trailing stop limit order tracks the market price, constantly recalculating the stop trigger price, which remains below the market price. The limit offset determines the limit order price, which is also subject to continuous adjustments.
As the market rises, the stop and limit prices increase by the trail and offset amounts, respectively. When the market declines, the stop price remains unchanged. Once the market price reaches the stop price, the limit order is executed.
Buy trailing stop limit orders function as the mirror image of sell orders, offering the same risk management and profit protection features.
Example of a Trailing Stop Loss
Let’s assume you purchased 1 Bitcoin (BTC) at a price of $60,000. After examining the price history, you observe that the price of BTC typically retraces (pulls back) between 6% and 10% before resuming an upward trend. These observations can guide you in determining an appropriate percentage for your trailing stop order.
Setting a trailing stop order between 4% and 6% might be too tight. This range can be reached even during normal price fluctuations. As a result, your trailing stop order could be triggered prematurely in a market with minimal volatility, leading to missed opportunities for higher returns. Conversely, setting the trailing stop order at 20% or 25% would be overly risky in a market characterized by 6% to 10% pullbacks.
In this scenario, the optimal trailing stop loss for BTC would be around 12% to 14%. This range allows for price fluctuations while providing a safety net. If the price drops more than 14% below your purchase price, your position will be protected.
With a 12% trailing stop, the order will be executed if the price falls 12% below your purchase price of $60,000, which equates to $52,800. Let’s suppose the price struggles to break above the $60,000 mark. You initially place your stop-loss order at $52,800. If the price then rises to $60,600, the trailing stop-loss order automatically adjusts upwards to $53,328 (12% below the new price level of $60,600).
Should the BTC price further appreciate to $75,000, the trailing stop order will remain in effect. If the price subsequently falls to $67,500 (10% below the peak), the trailing stop order will be executed as a short trade, locking in your profit. The trailing stop will then remain at $67,500, assuming the price doesn’t rebound after the drop. In this case, your profit would be $7,500.
Conclusion
Trailing stop orders can benefit both aggressive and conservative traders. Aggressive traders may opt for wider percentage ranges or target prices when setting their trailing intervals. Conversely, conservative traders typically prefer tighter settings to minimize potential losses.
Image source: FasterCapital
Traders who actively monitor market movements can always manually close their positions at opportune moments and initiate sell orders. This proactive approach ensures that trailing stops won’t negatively impact their overall trading performance, even in unfavorable market conditions.
FAQs
What are the benefits of a trailing stop order?
A trailing stop order is an additional order placed alongside a regular stop-loss order to mitigate risks and maximize potential profits. When taking a long position, it is set below the market price, allowing you to potentially buy at the most advantageous price without incurring additional risk.
How does a trailing stop order work?
As the price of an asset you’ve purchased increases, the trailing stop order rises in tandem. When the price stops rising, the stop-loss price remains at a favorable level, protecting you from selling the asset at a lower price and helping you capture greater profits.
What are common mistakes traders make when using trailing stop orders?
A frequent error is resetting the trailing stop during a short-term price decline, which can ultimately diminish profits. It’s generally advisable to let the trailing stop order function as intended, adjusting automatically to market fluctuations without unnecessary intervention.