The Benefits and Drawbacks of Trailing Stop Losses, as Well as How to Use Them

A trailing stop-loss order is a risk-mitigation strategy that lowers risk or locks in profit while adjusting for trader movement. When day trading, a trailing stop-loss is not required; it is a personal preference.

You’ll be better able to assess if this risk management strategy is suited for you and your trading methods after understanding more about the principles of trailing stop-loss orders.

What is the difference between a trailing stop-loss order and a regular stop-loss order?

A stop-loss order limits a trade’s risk. It is an offsetting order that allows a trader to exit a market order if the asset’s price goes in the incorrect direction and reaches the pre-determined stop-loss price.

Assume a trader purchases a stock at $54.25 and places a stop-loss order at $54.05. They’re putting up about $0.20 per share at risk because if the price drops below $54.05, the stop-loss order will kick in, allowing them to exit the deal. Depending on liquidity and volatility, they may not obtain exactly $54.05, but the stop-loss still works to reduce risk.

The trigger price of this stop-loss order remains unchanged. When using a trailing stop-loss, the stop-loss might move in lockstep with the price—but only in the trader’s benefit.

Trailing stop-losses will only move if they lower risk, and they will never raise your risk above the level set by your original stop price.

When using a trailing stop-loss, the price of the stop-loss trigger automatically rises (above $54.05) as the stock price rises. As long as the stock is moving in a positive direction, this effectively lowers the risk of the investment. Even if the stock hits the stop-loss price, the trader will earn if the stop-loss is eventually pushed above $54.25.

These commands can be used with long or short positions. If a trader buys a short position in a stock at $19.37 and uses a trailing stop-loss of $19.42, the stop will move lower as the stock price falls.

If the stop-loss order is adjusted below $19.37, the trader has a “locked-in profit” because the trade will profit even if the stock price hits the stop-loss order.

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How to Make Use of a Stop-Loss

Setting up automatic trailing stop-loss orders with the broker, manually changing the stop-loss order depending on price movements, or using technical indicators to determine your critical levels are all options for implementing a trailing stop-loss order.

Trailing Stop-Loss on the Basis of Price

The most basic trailing stop-loss strategy is to set a trailing stop amount and leave the rest to the brokerage.

A trader could, for example, buy a stock for $54.25 and set a trailing stop-loss of $0.20. A trailing stop-loss will increase the trade’s exit (stop-loss) to $0.20 below the most recent high (the exit would be $0.20 above the most recent low if the trader had shorted the stock instead of purchasing it).

The stop-loss would automatically increase up from $54.05 to $54.15 if the stock price rose from $54.25 to $54.35. When the price rises to $54.45, the stop-loss is raised to $54.25, and so on. If the price rises to $54.45 before plummeting, the trade will be terminated at $54.25 since the trailing stop-loss will liquidate the position when the price drops 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

Greater experienced traders prefer the manual trailing stop-loss because it gives them more control over when the stop-loss is moved. The order placed with the brokerage isn’t a trailing stop-loss order in this situation; instead, it’s a conventional stop-loss order. Rather of automating the process, the trader decides when and where the stop-loss order will be moved to limit risk.
Once a pullback has occurred and the price is once again increasing, it is typical practice for investors holding long positions in a stock to adjust the stop-loss up. The stop-loss is raised to just below the pullback’s swing low. A trader, for example, enters a transaction at $10.

The price rises to $10.06, then falls to $10.02 before rising again. The stop-loss could be raised to $10.01, which is close below the pullback’s low of $10.02.

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Once a pullback has happened and the price is falling again, the stop-loss is pushed lower if the trader holds a short position. The stop-loss is moved to just above the pullback’s swing high.

Trailing Stop-Loss Method Based on Indicators

A trailing stop-loss can be created using indicators, and some are built expressly for this purpose. When employing a trailing stop-loss based on an indicator, you must manually adjust the stop-loss to reflect the information displayed on the indicator.

The average true range (ATR), which gauges how much an asset generally moves over a particular time frame, is used in several trailing stop-loss indicators.

Indicators can be useful in indicating where a stop-loss should be placed, but no approach is ideal. On occasion, the indicator may get you out of trades too soon or too late. Before attempting to utilize any indicator with real money, test it out with demo trading and become familiar with its benefits and drawbacks.

The stop-loss may be trailed at a multiple of the ATR if a forex pair moves seven pips every ten minutes (the ATR would show this reading on the chart if using 10-minute price bars).

Assume you buy a forex pair for 1.1520 and set an initial stop-loss at 1.1506; you’re taking a 14-pip risk. Continue to trail the stop-loss 14 pips behind the highest price seen since entrance if the price increases in your favor. The stop-loss is raised up to 1.1516 if the price rises to 1.1530. (which is 1.1530-0.0014). Continue doing so until the price reaches the stop-loss and the deal is closed.

Several indicators, such as ATRTrailingStop, will print a trailing stop-loss on your chart. Chandelier Exits, like the parabolic SAR stop-loss indicator, are popular ATR trailing stop-loss indicators that can be used on price charts.

The Benefits and Drawbacks of Trailing Stop-Loss Orders

Advantages

  • Ride the waves with the least amount of risk.
  • Stop losing trades from becoming winning trades.
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Drawbacks

  • Stop levels are difficult to determine.
  • Doesn’t work in every market scenario

Advantages in Detail

  • If a large trend emerges, much of it will be captured for profit, assuming the trailing stop-loss is not struck throughout the trend. Allowing trades to run with the trend until they reach the trailing stop-loss, in other words, can result in significant profits.
  • Prevent losing trades from becoming winning trades by following these steps: If the price advances favorably at first but subsequently reverses, a trailing stop-loss is useful. The trailing stop-loss prevents a successful trade from becoming a loser, or at the very least decreases the amount of loss if a transaction fails.

Drawbacks in Detail

  • Stop levels are difficult to determine: Prices may make a brief, fast move that strikes your trailing stop-loss, but then continue in the planned direction without you. You could still be in the trade and profiting from positive price movements if you hadn’t altered the original stop-loss with a trailing order.
  • Trailing stop-losses don’t operate in all market conditions: When the price isn’t trending well, trailing stop-losses might result in a lot of losing trades since the price is constantly reverting and hitting the trailing stop-loss. If this happens, either stop trading or utilize the set-and-forget strategy. The set-and-forget strategy entails setting a stop and target depending on current market conditions, then letting the price hit one order or the other without making any adjustments.

Final Thoughts

Trading is difficult, and no ideal solution to the issues stated above exists. When significant moves occur, a trailing stop-loss can be quite useful in capturing them.

If the market isn’t making big changes, a trailing stop-loss can wreak havoc on your performance as little losses eat away at your cash.

Any trailing stop-loss strategy you deploy should be tested in a demo account before using real money. Spend several months honing your trailing stop-loss approach and making sure it works.


Read also: The CPI and Forex: How CPI Data Affects Currency Prices

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