Introduction
There are various techniques that traders can use to increase profits and cut losses.
One of the most common ways that traders achieve this is by using bracket orders.
This simply means that when they place a trade and get filled, a profit target and stop-loss orders are automatically placed around the entry price (hence the term “bracket”) and the final result will be a controlled loss or a predetermined profit.
While this works well for many, it’s not the only way!
Bracket orders are somewhat static and can actually restrict profit potential when market conditions are trending and ripe with opportunity.
So how can a trader still manage their downside risk while increasing profits?
Enter the trailing stop order!
What Is a Trailing Stop?
A trailing stop is a type of stop-loss order that traders can use to limit downside risk while locking in profits as a trade runs in their favor – for this reason – trailing stops are often referred to as “profit protecting stops”.
This is because you will only ever exit the trade if the market reverses by a predetermined amount!
A trailing stop can be set to “trail” the market at a certain percentage or dollar amount above/below the market price.
Most brokers and software platforms allow traders to set these up automatically. However, traders can also manually implement a trailing stop.
Differences between Stop-Loss Orders and Trailing Stop Orders
You might be wondering how a stop-loss order is different from a trailing stop order!
A stop-loss order specifies that you want to get out of a position at market price when the asset falls to a certain level that you set. This price level is generally set below the entry price and is designed to cut losses and protect capital.
Let’s say you get long (buy) 100 shares of Apple at $100 with a stop loss at $95.00. If the price of Apple stock falls to $95.00, your position will be sold out at the market for a controlled loss.
A trailing stop order is a type of stop loss order that is designed to limit downside while simultaneously locking in profits so long as the price is moving in favor of the trade direction. This type of order can be set at a defined percentage amount OR dollar amount away from the entry price.
Using the example of Apple again, let’s say you get long (buy) 100 shares of Apple at $100 using a 5% trailing stop. In this case, the original stop loss location would be set at the $95.00 price level, which represents a 5% retracement from the entry price. If the price of Apple stock does not go above $100, the stop will remain at $95.00.
If the price of Apple moves to $110 then the trailing stop loss will automatically move up to $104.50 (which is 5% below $110), effectively locking in some profits on the trade.
In the case of a buy trade, the trailing stop will only move up once a new high has been established. After it moves up, it cannot move back down.
So if Apple stock stays below $110, the stop loss will remain fixed at $104.50 until the market retraces back to this level and you get sold out of the position or another high is established and the process repeats.
In this example, we used a fixed percentage to the trail, however, if you use a fixed dollar amount the idea remains the same!
Why Use a Trailing Stop?
So why would you consider using a trailing stop?
Because we cannot predict how long a trend will last and a trailing stop will provide you with an opportunity to maximize your potential profits while the trend lives on.
But what about the downsides? Truth be told, the major disadvantage to trailing stops is mainly psychological!
This is because there are only certain market conditions where trailing stops can be effective and this is when the markets are trending.
A majority of the time, however, you will watch your winners turn into losers as price initially moves in your favor and then reverse to take you out of the trade.
When you use trailing stops, you will always be getting paid less than you had previously, so you will never be exiting the trade at the point where it was the most profitable.
This can mess with your psychology and lead to frustration and emotional trading, especially if you are a newer trader, so we’d recommend experimenting with trailing stops only once you have established a track record of consistent profitability using fixed profit targets.
For more information on some common trailing stop mistakes and how to use them the right way, check out this youtube video we put together here:
Final Words on Trailing Stop Loss Orders
The trailing stop order can be an effective way to potentially increase the returns on your trades while keeping downside limited – but it must be used correctly!
If you place too tight of a trailing stop, you might find yourself getting taken out for small profits only to see the market continue trending in your direction without you.
The opposite holds true for placing too wide of a trailing stop as you might just find yourself giving back a majority of your unrealized profits only to get emotional and revenge trade in an attempt to get back to what you “had”.
There is a time and place to employ trailing stops and after enough screen time and experience in the markets, you will be in a better position to use them effectively!
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The information contained in this post is solely for educational purposes and does not constitute investment advice. The risk of trading in securities markets can be substantial. You should carefully consider if engaging in such activity is suitable for your own financial situation. TRADEPRO Academy is not responsible for any liabilities arising as a result of your market involvement or individual trade activities.
