We are always looking for new strategies to help limit potential losses. The most common tool in the risk management armoury is a stop-loss order, which states that if an asset's price hits a specified level, the position will be closed at or near the stop-loss order price to prevent additional losses.
What if you could automatically move your stop loss in the direction of your trade and lock in a profit? That's right. You can do it with a trailing stop order. A trailing stop is set on an open position at a predetermined distance from the current price of an asset. Points are used to calculate distance.
The trailing stop's primary goal is to lock in profits. Utilising a trailing stop also limits potential losses whilst setting a tolerance as to how much of your locked-in profits you are comfortable risking for potential future gains on the specific trade.
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A trailing stop is a stop-loss order placed at a certain distance (measured in a number of points) from an asset's current market price. For a short position, a trailing stop is placed above the current price, and for a long position, it is placed below the current price. Each broker normally has a minimum amount of points; the trailing stop needs to be placed above or below the market price.
Trailing stops allow you to lock in gains while leaving the trade open until the price of the instrument reaches your trailing stop level or a take profit limit (if you have set any). The stop-loss order is executed, and your position will be closed when the market price hits your trailing stop.
If the market continues to move in a favoured direction, so does the trailing stop, which maintains the stop loss at a predetermined distance from the current price. When the market stops moving in a profitable direction, the trailing stop doesn't move.
If the market price moves in your favour but then reverses, the trailing stop will not reverse. If the reversal goes through the trailing stop, the position will be closed, either limiting your loss or locking in a profit. This means you can step away from the computer screen and have confidence that your positions are being properly managed.
Let's understand this with an example:
You have a long position on the EURUSD at 1.1250, and you put a trailing stop 100 pips below your opening price. The trailing stop will shift (or trail) your open position to the upside with each pip movement. The trailing stop will be moved to 1.1151 if the market price rises to 1.1251. The trailing stop will move up to 1.1180 if the market price hits 1.1280.
Nevertheless, if the price reverses after reaching 1.1280, the trailing stop will remain at its most recent level of 1.1180. Trailing stops, as you can see, automatically lower your potential loss when compared to regular stop-loss orders since they tighten with each new favourable price tick.
Lastly, if you're wondering if trailing stops can expire, they have no time limit. You may keep them active indefinitely, although they are automatically cancelled when your position is closed.
Unlike a normal stop loss order, the trailing stop allows you to lock in profits automatically. As a result, it serves as a seat belt for your position. Not only that, but it allows you to lock in even larger profits if the market continues to move in your favour.
The trailing stop changes in real time in response to price movement. As a result, it's a fantastic risk management tool, allowing you to capitalise on sharp market moves while protecting against a market trend reversal.
Since the trailing stop handles it for us, we don't have to be in front of the screen to manually modify the stop loss when the market moves. Speed is of the essence when market volatility increases, and manual position management may be time-consuming.
Trailing stops protect day traders and scalpers from sharp market moves. In addition, the trailing stop enables them to have a stop loss that changes with their positions in real-time.
The trailing stop is very useful for swing and trend-following traders who hold their positions for days or weeks.
The trailing stop is particularly useful if you are trading in the direction of a trend. But it may be difficult to use in markets which are stuck in tight ranges. In times of extreme market volatility, there is the danger that trailing stops get triggered quickly on wild price swings.
There are two approaches you may take:
Increase the trailing stop loss distance to endure short-term corrections without systematically closing the order (but this also raises your risk).
Deactivate the trailing stop when you identify a ranging market or a period of extreme volatility. Instead, utilise a traditional stop loss until the market returns to the trend.
To summarise, a trailing stop-loss is a free risk management tool that may help you reduce risk and maximise your profits by moving your stop orders automatically. Since the trailing stop only changes when the market price moves in your favour, it's a good trading tool that could help you lock in profits automatically without constantly moving your stop orders manually.
A trailing stop is strategically implemented once a position is already in profit. Your first and foremost priority is to protect capital!
There are many ways to determine where you should place a trailing stop loss, but the most popular methods all involve technical analysis:
Calculate the number of pips using the ‘Average True Range’ (ATR).
Count the pips from your opening level to the next significant area of support/resistance.
Use Fibonacci Retracement levels to calculate the pips from your opening level to significant Fibonacci percentages.
Trailing stops are useful because they help you manage your positions automatically, moving your stop to reduce your risk for as long as the market moves in your favour.
If the market continues to move in your favour, without correcting and triggering your trailing stop, then you could lock in a profit. All this is carried out automatically, helping traders in dealing with the psychological effects of turbulent markets.