What Is Trailing Stop Loss and How to Use It?

Traders keep looking for a way to minimize or prevent losses. This is where such strategies as stop-loss orders may come in handy. The mechanism comes as effective market exit tactics in case the asset price hits a predefined level.

However, such strategies have some obvious downsides. What's more, they can sometimes result in further losses if used inappropriately. Traders always need to keep up with the current market price. For this reason, they may need a bit more flexible tools such as a trailing stop loss strategy.

Trailing Stop Loss Order Explained

A trailing stop-loss order refers to the day trading type of order. It helps to set the maximum percentage or value a trader can lose on a traded instrument. The key feature here is that a pre-set level will change along with the price moving up or down in the favor of a trader. And vice versa, if the price moves against the trader, the stop price will stay fixed and remain at the same level.

In other words, trailing stop loss offers a moving stop price, which makes the strategy more flexible no matter what happens to the security price. We actually have the type of order that makes it possible for traders to lock them in profits. Besides, it provides additional loss protection when day trading.

Another great feature of the tactics is that a trailing stop-loss order does not require manual configuration. It can act automatically with the ability to change settings and configure it the way you need it.

Here is what you need to know about trailing stop loss:

  • It helps to set the maximum percentage of the loss;
  • The stop price moves or stands still is the security price moves in favor of or against the trader;
  • You can use this type of order to prevent significant losses during day trading.

Now, let's see how the stop-loss order works.

How Trailing Stop Loss Order Works

There is nothing difficult in placing this type of order. It works the same way as a typical stop-loss strategy. However, it will depend on the type of trade you are getting in. It can be either a long or short trade. For instance, if you sell an asset that you have during a long trade, the stop price should be set below the level of the entry point.

Have a look at the trailing stop loss example below.

Trailing Stop Loss Order Example

To figure out how the strategy works under real market conditions, let's consider you trade stock with the following:

  1. $10 is the purchase price;
  2. $10.05 is the last price when you set the trailing stop.
  3. $0.20 is the trailing amount.
  4. $9.85 is the instant stop-loss value considered as effective.

As we have mentioned earlier, a trailing stop-loss order is a moving order. If the market goes up to $10.97, the stop value will change and climb to $10.77. In case the asset price falls back to $10.90, the stop value will remain at the same level. But if it keeps on going down and reaches $10.76, your stop level will change while the market order will be triggered instantly.

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You should keep in mind that the market might witness momentary price drops. When this happens, some traders try to reset the stop level on impulse. However, you are recommended to leave it as it is. Otherwise, you may end up with even lower stop-loss than you expected.

Trailing Stop Loss Downsides

The main drawback of the strategy is the fact you may get out of the trade sooner than you expect. What's more, it may happen when the asset price is lightly dropping but not actually pulling back hard or reversing. In other words, the exit order can be triggered without obvious reasons for that. So, make sure to place the stop level on a distance that the price is not supposed to reach.

The key to success here is to define how much room you may reserve for a particular trade. Is it going to be 10 or 20 cents? Whatever you do, make sure you analyze your order and double-check it before placing a stop price.

This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer of or solicitation for any transactions in financial instruments. Before making any investment decisions, you should seek advice from independent financial advisors to ensure you understand the risks.

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