Definition and Example of a Trailing Stop Loss
A trailing stop loss is a kind of order that is intended to help you lock in profits while protecting you from day trading losses. It caps the amount that will be lost if the trade doesn't work out but doesn't cap the potential gain if the trade works in your favor. This type of order converts into a market order when the security price reaches the stop price.
Because your trade will be carried out at the then-available market price, it may be executed at a price somewhat above or below the stop price.
Trailing stops can be set up to work automatically with most brokers and trading systems or can be manually monitored and changed by the trader.
How a Trailing Stop Loss Works
A trailing stop-loss order is initially placed in the same manner as a regular stop-loss order. For example, a trailing stop for a long trade (selling an asset you have) would be a sell order and would be placed at a price below the trade entry point. The main difference between a regular stop loss and a trailing stop loss is that the trailing one moves whenever the price moves in your favor.
For example, for every five cents that the price moves up, the trailing stop would also move up five cents. If the price were to move up 10 cents, the stop loss would also move up 10 cents. But if the price were to start to fall, the stop loss wouldn't move.
Suppose you were to enter a long trade at $40, with a 10-cent trailing stop at $39.90. If the price then were to move up to $40.10, the trailing stop would move to $40. At $40.20, the trailing stop would move to $40.10.
If the price then were to move back down to $40.15, the trailing stop would stay at $40.10. If the price were to continue down and reache $40.10, the trailing stop-loss order would be converted to a market order, and you would be able to exit the trade at about $40.10, having protected about 10 cents of profit per share.
|Long Trade Trailing Stop|
|Price||Price Movement||Trailing Stop Loss||Profit|
The scenario for a short trade (selling a borrowed asset and then waiting to buy it back at a cheaper price) is similar except that you are expecting the price to drop, so the trailing stop loss is placed above the entry price. Suppose you're entering a short trade by selling borrowed stock at $20 a share. With a 10-cent trailing stop-loss order, you would be "stopped out" with a 10-cent loss if the price were to move up to $20.10.
If the price instead were to drop to $19.80, the stop loss would drop to $19.90. If the price were to rise to $19.85, the stop loss would stay where it is. If the price were to fall to $19.70, the stop loss would fall to $19.80. If the price were to rise to $19.80 or higher, your order will be converted to a market order, and you would exit the trade with a gain of about 20 cents per share.
|Short Trade Trailing Stop|
|Price||Price Movement||Trailing Stop||Profit|
What Trailing Stops Mean for Individual Investors
One thing to be aware of about trailing stop-loss orders is that they can get you out of a trade too soon, such as when the price is only pulling back a bit, not actually reversing. To try to prevent that scenario, 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 is larger than 10 cents—but not so large that the entire point of the trailing stop would be negated.
Another criticism is that trailing stops don't protect you from major market moves that are greater than your stop placement. If you set up a stop to prevent a 5% loss but the market suddenly moves against you by 20%, the stop doesn't help 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 5% loss point.
How to Place or Move a Stop Loss
Most brokers provide a trailing stop-loss order option. Determine how much room you want to give the trade, such as 10 to 20 cents, and double-check your order. Your stop loss should 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.
Alternatives to Trailing Stop Losses
The main alternative to a trailing stop-loss order is the trailing stop limit order. It differs only in that once the stop price is reached, the trade is executed at the limit price you have set—or a better price—rather than at the then-available market price.
- A trailing stop loss is a type of trading order that lets you set a maximum value or percentage of loss you could incur.
- The stop price moves with the market price when the market is moving in your favor; it stays in place when the market is moving against you.
- This type of order is meant to lock in profits while protecting you from significant losses.
- It converts into a market order when the security price reaches the stop price and is executed at the then-available price.
Interactive Brokers. "Trailing Stop Orders." Accessed Dec. 6, 2021.
Charles Schwab & Co. "Trailing Stop Orders: Mastering Order Types." Accessed Dec. 6, 2021.
Charles Schwab & Co. "Be Defensive: Use Stop Orders." Accessed Dec. 6, 2021.
Seeking Alpha. "Why We Don't Use Stop Losses Or Other Triggered Actions." Accessed Dec. 6, 2021.
Interactive Brokers. "Trailing Stop Limit Orders." Accessed Dec. 6, 2021.