What Is a Trailing Stop Loss in Day Trading?
A trailing stop is a type of stop-loss order that combines elements of both risk management and trade management. Trailing stops are also known as profit protecting stops because they help lock in profit on a trade while also capping the amount that will be lost if the trade doesn't work out. Trailing stops can be set up to work automatically with most brokers/software, or a trailing stop can be manually implemented by the trader.
How a Trailing Stop Works
A trailing stop is initially placed in the same manner as a regular stop loss order. For example, a trailing stop for a long trade would be a sell order and would be placed at a price that was below the trade entry. The main difference between a regular stop loss and a trailing stop is that the trailing stop moves as the price moves. For example, for every five cents that the price moves, the trailing stop would also move five cents. Trailing stops only move in direction of the trade, so if you are long and price moves up 10 cents, the stop-loss will also move up 10 cents. But, if the price starts to fall, the stop loss doesn't move.
If a long trade is entered at $40, a ten cent trailing stop would be placed at $39.90. If the price then moved up to $40.10, the trailing stop would move to $40. If the price continued up to $40.20, the trailing stop would move to $40.10. If the price then moved back down to $40.15, the trailing stop would stay at $40.10. If the price continued down and reached $40.10, the trailing stop would exit the trade at $40.10, having protected ten cents of profit (per share).
It is the same scenario for a short trade, except that we are expecting the price to drop, and therefore a trailing stop loss is initially placed above the entry price. If a short trade is entered at $20 with a 10 cent trailing stop-loss, if the price moves to up $20.10, we are stopped out with a 10 cent loss. If the price drops to $19.80, our stop loss will drop to $19.90. If the price rises to $19.85, our stop loss stays where it is. If the price falls to $19.70, our stop loss falls to $19.80. If the price rises to $19.80, or higher, we will be stopped out of the trade with a 20 cent profit (per share).
How Not to Use a Trailing Stop
A common mistake is to place a trailing stop that is too close to the current price. An example would be a one or two cent trailing stop loss. Most stock prices are always gyrating by at least a couple cents every minute, so placing the trailing stop loss too close to the entry will typically result in being stopped out before any meaningful sized price moves occur.
Trailing stops should be placed at a distance from the current price that you do not expect to be reached unless the market changes its direction. For example, a market that usually fluctuates within a 10 cent range while it is still moving in the same overall trending direction would need a trailing stop that was larger than ten cents, but not so large that the entire point of the trailing stop is negated.
As a general rule, the stop loss should get you out of a trade if there is a high likelihood of the price reversing on your trade and erasing your profit.
Trailing stops are beneficial in that they lock in profit as the price moves in our favor. The drawback is that sometimes they get us out of a trade at an inopportune time (the price isn't actually reversing, but just pulling back a bit). An alternative to a trailing stop loss is to use a profit target.
How to Place or Move a Stop Loss
Most brokers provide a trailing stop loss order type. When placing a stop loss, select "Trailing Stop" or "Trailing Stop Loss". Set how much room you want to give the trade, for example, 10 cents, 20 cents, 5 cents, etc. Confirm the order and your stop loss will now move automatically as the price moves.
Traders can also trail their stop loss manually. They simply change the price of their stop loss as the price moves.
Final Word on Trailing Stop Loss Orders
Some traders use trailing stops with every trade that they make, and some traders never use trailing stops. The choice is yours. Profit targets are also a viable exit and can be used instead of, or in conjunction with, a trailing stop loss. Set a stop loss to move automatically, or manually adjust (trail) the stop-loss yourself. Don't set a trailing stop loss too close to the entry, as that will likely result in a premature exit. The purpose of the trailing stop loss is to capture profit as the price moves in our direction and to get us out if the price is potentially reversing.
Updated by Cory Mitchell, CMT.