What is a Trailing Stop
A trailing stop is a stop order that can be set at a defined percentage away from a security's current market price. An investor places a trailing stop for a long position below the security’s current market price; for a short position, they set it above the current price. A trailing stop is designed to protect gains by enabling a trade to remain open and continue to profit as long as the price is moving in the investor’s favor, but closes the trade if the price changes direction by a specified percentage. A trailing stop can also specify a dollar amount instead of a percentage.
How to Use Trailing Stops
BREAKING DOWN Trailing Stop
A trailing stop is more flexible than a fixed stop-loss order, as it automatically tracks the stock's price direction and does not have to be manually reset like the fixed stop-loss. Similar to all stop orders, a trailing stop enforces trading discipline by taking the emotion out of the “sell” decision, thus enabling traders and investors to protect profits and investment capital.
Investors can use trailing stops for other asset classes, such as forex and cryptocurrencies. Like other stop orders, trailing stops can be set as limit orders or market orders. Unlike conventional stop orders that are held on the market book at the exchange, trailing stop orders are monitored on the brokerage's trading platform. Trailing stops can also get programmed into algorithmic trading strategies.
Trailing Stop Example
Assume you purchased a stock at $10. You could place a 15% trailing stop order to protect your capital; this means that, if the stock declines by 15% or more, the trailing stop gets triggered, thereby minimizing your loss. Suppose the stock moves up to $14 over the next few months and, while you have enjoyed its appreciation, you are concerned it may retrace its gains. Recall that your trailing stop is in place, so, if the stock plunges 15% or more, it would be triggered. You could decide to tighten the trailing stop to 10% to protect as much profit as possible, while still giving the position room to run.
Let’s assume the stock moves up to $15 and then subsequently declines 10% to $13.50. The 10% price drop would trigger your trailing stop, and, assuming the trade executes at $13.50, you make a 35% gain on your long position (i.e., the difference between $10 and $13.50).
The key to using a trailing stop successfully is to set it at a level that is neither too tight (to prevent the trade getting stopped out before it has a chance to work) nor too wide (which, if triggered, may result in giving back a significant portion of unrealized profit).