A trailing stop-loss order is a risk-reduction tactic that reduces risk or locks in profit while adjusting for movement in the trader's favor. A trailing stop-loss is not a requirement when day trading; it's a personal choice.
After learning more about the basics of trailing stop-loss orders, you'll be better able to determine if this risk management approach is right for you and your trading strategies.
What Is a Trailing Stop-Loss Order?
A stop-loss order controls the risk of a trade. It is an offsetting order that gets a trader out of a trade with a market order if the price of the asset moves in the wrong direction and hits the pre-determined stop-loss price.
For example, assume a trader buys a stock at $54.25 and places a stop-loss at $54.05. They are risking roughly $0.20 per share because if the price drops to $54.05, the stop-loss order will execute to get them out of the trade. They may not get exactly $54.05, depending on liquidity and volatility, but the stop-loss still works to limit risk.
This stop-loss order is stagnant; the trigger price doesn't move. If a trailing stop-loss is used, then the stop-loss can move as the price moves—but only in the trader's favor. Trailing stop-losses will only move if they reduce risk, and they will never increase your risk beyond your original stop price.
With a trailing stop-loss, the stop-loss trigger price automatically increases (above $54.05) as the price of the stock price moves up. In effect, this further reduces the risk of the trade as long as the stock is moving favorably. If the stop-loss is eventually moved above $54.25, then the trader will make a profit even if the stock hits the stop-loss price.
These orders work with long or short positions. If a trader takes a short position in a stock at $19.37 with a trailing stop-loss at $19.42, then the stop will decrease as the stock price drops. If the stop-loss is moved below $19.37, then the trader has a "locked-in profit" because, even if the stock price hits the stop-loss order, the trader will realize a profit on the trade.
Ways to Utilize a Stop-Loss
There are multiple ways to implement a trailing stop-loss order, including setting up automatic trailing stop-loss orders with the broker, adjusting the stop-loss order manually based on price movements, or using technical indicators to set your key levels.
Price-Based Trailing Stop-Loss
The most straightforward trailing stop-loss method is to establish a trailing stop amount and let the brokerage do the rest.
For example, a trader could buy a stock at $54.25 and place a trailing stop-loss of $0.20. A trailing stop-loss will move the exit (stop-loss) of the trade to $0.20 below the most recent high (if the trader had shorted the stock instead of buying it, the exit would be $0.20 above the most recent low).
If the stock price rises from $54.25 to $54.35, the stop-loss would automatically move up from $54.05 to $54.15. If the price moves up to $54.45, the stop-loss moves to $54.25, and so on. If the price peaks at $54.45 and then comes crashing down, the trade will be closed at $54.25 because the trailing stop-loss will liquidate that position after the price falls by $0.20.
If a trader doesn't want to wait for the trailing stop-loss to hit, they can choose a profit target and keep the trailing stop-loss in place until that profit target is hit.
Manual Trailing Stop-Loss Method
The manual trailing stop-loss is commonly used by more experienced traders, as it provides more flexibility as to when the stop-loss is moved. In this case, the order placed with the brokerage isn't actually a trailing stop-loss order, it's just a standard stop-loss order. Instead of automating the process, the trader determines when and where they will move the stop-loss order to reduce risk.
A common tactic for those with a long position in a stock is to move the stop-loss up only once a pullback has occurred and the price is once again rising. The stop-loss is moved up to just below the swing low of the pullback. For example, a trader enters a trade at $10. The price moves up to $10.06, drops to $10.02, and then starts to move back up. The stop-loss could be moved up to $10.01, just below the low of the pullback at $10.02.
If the trader has a short position, the stop-loss is moved down once a pullback has occurred and the price is falling again. The stop-loss is moved to just above the swing high of the pullback.
Indicator-Based Trailing Stop-Loss Method
Indicators can be used to create a trailing stop-loss, and some are designed specifically for this function. When using an indicator-based trailing stop-loss, you have to manually move the stop-loss to reflect the information shown on the indicator. Many trailing stop-loss indicators are based on the average true range (ATR), which measures how much an asset typically moves over a given time frame.
Indicators can be effective in highlighting where to place a stop-loss, but no method is perfect. The indicator may get you out of trades too early or too late on some occasions. Test out any indicator you use with demo trading first, and be aware of its pros and cons before attempting to use it with real capital.
If a forex pair typically moves seven pips every 10 minutes (the ATR would show this reading on the chart if using 10-minute price bars), the stop-loss could be trailed at a multiple of the ATR. For example, assume you buy a forex pair at 1.1520 and place an initial stop-loss at 1.1506; this is a risk of 14 pips. If the price moves in your favor, continue to trail the stop-loss 14 pips behind the highest price witnessed since entry. If the price rises to 1.1530, the stop-loss is moved up to 1.1516 (which is 1.1530 - 0.0014). Continue to do this until the price eventually hits the stop-loss and closes the trade.
Several indicators will plot a trailing stop-loss on your chart, such as ATRTrailingStop. Chandelier Exits are another common ATR trailing stop-loss indicator that can be applied to price charts, as well as the Parabolic SAR stop-loss indicator, although it is not based on ATR. A moving average can also function as a trailing stop-loss indicator. The settings on these indicators can be changed to suit your preferences.
Pros and Cons of Trailing Stop-Loss Orders
Ride trends with minimal risk
Prevent winning trades from becoming losing trades
Difficult to determine stop levels
Doesn't work in all market conditions
- Ride trends with minimal risk: If a big trend develops, much of that trend will be captured for profit, assuming the trailing stop-loss is not hit during that trend. In other words, allowing trades to run with the trend until they hit the trailing stop-loss can result in big gains.
- Prevent winning trades from becoming losing trades: A trailing stop-loss is beneficial if the price initially moves favorably but then reverses. The trailing stop-loss helps prevent a winning trade from turning into a loser—or it at least reduces the amount of the loss if a trade doesn't work out.
- Difficult to determine stop levels: Sometimes prices will make a brief, sharp move, which hits your trailing stop-loss, but then keeps going in the intended direction without you. Had you not adjusted the original stop-loss with a trailing order, you could still be in the trade and benefiting from favorable price moves.
- Doesn't work in all market conditions: During periods when the price isn't trending well, trailing stop-losses can result in numerous losing trades because the price is continuously reversing and hitting the trailing stop-loss. If this is occurring, either don't trade or use the set-and-forget approach. The set-and-forget approach is when you place a stop and target—based on current conditions—and then just let the price hit one order or the other with no adjustments.
The Bottom Line
Trading is not easy, and there is no perfect solution to the problems mentioned above. Sometimes a trailing stop-loss works great in capturing large moves when those moves occur. If the market isn't making large moves, then a trailing stop-loss can significantly hamper performance as small losses whittle away your capital, bit by bit.
No matter what trailing stop-loss approach you use, test it in a demo account before utilizing real capital. Spend several months practicing and making sure that your trailing stop-loss strategy is effective.