How to Use a Trailing Stop-Loss While Day Trading
Pros and Cons of Trailing Stop Losses, and How to Use Them
A trailing stop-loss order is a risk-reduction tactic where the risk on a trade is reduced, or a profit is locked in, as the trade moves 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.
Trailing Stop-Loss Order Explained
A stop-loss order controls the risk of a trade. It is an offsetting order that gets a trader out of a trade if the price of the asset moves in the wrong direction and hits the price the stop-loss order is placed at.
For example, assume a trader buys a stock at $54.25 and places a stop-loss at $54.05. They are risking $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. This stop-loss order doesn't move whether the price goes up or down; it stays where it is.
If a trailing stop-loss is used, then the stop-loss can be moved as the price moves—but only to reduce risk, never to increase risk. With a trailing stop-loss, the trader moves the stop-loss up (above $54.05) as the price of the stock price moves up, reducing the risk of the trade while 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.
If a trader takes a short position in a stock at $19.37 with a stop-loss at $19.42 and opts to trail this stop-loss, it can be moved down as the 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. The stop-loss order should not be moved up when in a short position.
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 or adjusting the stop-loss order manually based on price movements or technical indicators.
Price-Based Trailing Stop-Loss
Say a trader buys a stock at $54.25 and places a stop-loss at $54.05. This trader has a stop-loss order of $0.20. The trader could also use a $0.20 trailing stop-loss. A trailing stop-loss will move the exit (stop-loss) of the trade to $0.20 below the most recent high (occurring after entry) when long, or $0.20 above the most recent low when short.
For example, if the stock price rises from $54.25 to $54.35, the stop-loss would automatically move up to $54.15 from $54.05. If the price moves up to $54.45, the stop-loss moves to $54.25, or breakeven. If the stock continues to rise to $54.49, the stop-loss will be at $54.29. If the price of the stock starts to drop, the stop-loss will not move down—it only moves up if in a long position, or lower if in a short position.
If the price falls to $54.29, the trade will be closed because the trailing stop-loss will liquidate that position. The trailing stop-loss will stay at $54.29 until the price hits it or will move up one cent for every cent the price moves above $54.49.
If a trader takes a short position in a stock at $19.37 and has a stop-loss at $19.42, they are risking $0.05 per share. If this is a trailing stop-loss order, for each cent the price drops below $19.37, the stop-loss will also drop by one cent. If the price declines to $19.20, the trailing stop-loss will be at $19.25, locking in a profit for the trader. Once the trailing stop-loss drops, it doesn't move back up again. The price will eventually hit the trailing stop-loss level, or the trader can exit via another means—such as choosing a profit target, or simply closing the trade manually.
This is the basic and automatic version of a trailing stop-loss which is available on most trading platforms. When setting up a stop-loss order, you would set the stop-loss type to trailing.
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 stop-loss order is not set as trailing; instead, it is just a standard stop-loss order. The trader determines when and where they will move the stop-loss order to reduce risk.
A common tactic, if holding 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 again. The stop-loss could be moved up to $10.01, just below the low of the pullback at $10.02.
Figure 1 shows an example of this tactic being used on a 1-minute chart. 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.
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.
There are several indicators that will plot a trailing stop-loss on your chart, such as ATRTrailingStop. Figure 2 shows the indicator applied to a EURUSD 1-minute chart. If you initiate a short trade, stay in the trade as long as the price bars are below the dots. If in a long trade, stay in the trade while the price bars are above the dots. The ATRTrailingStop indicator, or other indicators like it, shouldn't necessarily be used for trade entry signals. The indicator does a good job of keeping a trader in trend trade once a trend begins, but using it to enter trades can result in a substantial number of whipsaws. The settings can be changed on the indicator to suit your preferences. The Figure 2 chart example uses a 5-period ATR with a 3.5x multiplier on the ATR.
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.
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.
Pros and Cons of Trailing Stop-Loss Orders.
The positives of a trailing stop-loss are that 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 until they hit the trailing stop-loss can result in big gains. A trailing stop-loss is also 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 at least reduces the amount of the loss if a trade doesn't work out.
The downside of using a trailing stop-loss is that markets don't always move in perfect flow. Sometimes the price 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, you could still be in the trade and benefiting from favorable price moves.
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 the 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.
Final Word on Using Trailing Stop-Loss Orders
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.