What does trailing stop order mean?
A trailing stop order is a type of order that automatically adjusts the stop loss level as the market moves in your favor. This means that instead of setting a fixed price for your stop loss, you set a percentage or dollar amount away from the current market price. The key difference between a trailing stop order and a regular stop loss order is that the first one allows you to capture more gains if the market keeps moving in your favor.
For example:
Let's say you buy a stock at $50 per share and set a trailing stop order at 10%. This means that if the stock falls 10% from its highest point after you bought it, your stop loss order will trigger and sell your shares. But if the stock rises to $60 per share, your stop loss order will move up to $54 (10% below $60). This way, you can capture more gains if the market keeps moving in your favor.
This can be a powerful tool for traders who want to possibly maximize their potential. By automating your exit strategy and giving your trades room to breathe, you can capture more gains and reduce stress. However, it's important to use it wisely and consider their pros and cons before implementing it in your trading strategy.
A practical example
To better understand how a trailing stop order works, let's take a look at an example.
Suppose you decide to buy 100 shares of XYZ Corp at $50 per share. You believe the stock has potential to rise, but you also want to limit your potential losses in case the market goes against you. You set a trailing stop order at 5%, which means that if the stock falls 5% from its highest point after you bought it, your stop loss order will trigger and sell your shares.
A few days later, the stock starts to rise. It hits $55 per share, and your trailing stop order moves up to $52.25 (5% below $55). A week later, XYZ Corp starts to fall, triggering your trailing stop order at $52.25. Your shares are sold automatically, with a gain of $2.25 per share.
If you had set a regular stop loss order (for example at $49.50), you would have sold your shares as soon as the stock hit that price, missing out on the potential gains. With the trailing stop order, you were able to capture some gains while also protecting yourself from further losses.
Why use trailing stop?
Traders use trailing stop orders for several reasons:
- The primary reason is to manage risk and limit potential losses. By setting it, they can protect their investments from significant market downturns while still being able to capture gains when the market moves in their favor.
- Another reason to use it is to reduce stress and emotional decision-making. When traders set a regular stop loss order, they may be tempted to panic and sell their shares as soon as the market starts to dip. This can lead to missed opportunities for gains and unnecessary losses. With a trailing stop order, they can set a dynamic stop loss level that adjusts as the market moves in their favor, reducing the need for constant monitoring and decision-making.
However, it's important to use trailing stop orders wisely and understand their limitations. Traders should consider their investment goals, risk tolerance, and market conditions before implementing it in their strategy.
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Advantages & disadvantages
Like any trading tool, trailing stop orders have pros and cons. Let’s have a look at the main ones in the following table.
| Advantages | Disadvantages |
|---|---|
| It helps traders manage their risk and limit potential losses. Traders can automatically exit a trade if the price moves against them beyond a certain point. | Stop loss orders may not be suitable for all investors, particularly those with a low risk tolerance. Someone may prefer to take a more hands-on approach to managing their trades. |
| It allows traders to capture gains as the market rises. By setting a trailing stop loss, traders can lock in profits as the price moves in their favor. | They are subject to market volatility and in fast-moving markets, the price may move beyond the stop loss level before the order can be filled. |
| By automating the stop loss process, traders can reduce stress and emotional decision-making. | During periods of rapid price fluctuations, stop loss orders may not always be effective. |
| A dynamic stop loss level adjusts as the market moves in favor of the trader. | Stop loss orders may not be appropriate for all types of securities or trading styles. For example, some traders may prefer to use options or other derivatives to manage their risk. |
Stop loss vs trailing stop order
Stop loss and trailing stop orders are two popular risk management tools used by traders. While they both aim to limit potential losses, there are some key differences between the two.
| Stop loss order | Trailing stop order | |
|---|---|---|
| Definition | An order to sell a security at a specified price to limit the loss. | An order to sell a security if its price falls below a certain percentage or dollar amount from the highest price since the order was placed. |
| Purpose | To limit potential losses by selling a security at a predetermined price. | To protect profits by selling a security if its price falls below a certain percentage or dollar amount from the highest price since the order was placed. |
| Execution | The order is executed at the specified stop loss price. | The order is executed when the trailing stop price is reached. |
| Price determination | The stop loss price is set by the investor. | The trailing stop price is determined by a percentage or dollar amount below the highest price since the order was placed. |
| Flexibility | Once set, the stop loss price remains fixed. | The trailing stop price can be adjusted as the security's price increases. |
| Risk | There is a risk of selling too early if the stop loss price is set too close to the current market price. | There is a risk of selling too late if the trailing stop price is set too far from the current market price. |
| Cost | There may be fees associated with placing a stop loss order. | There may be fees associated with placing a trailing stop order. |
| Market volatility | Stop loss orders may not be executed during times of high market volatility. | Trailing stop orders may be more effective during times of high market volatility. |
| Overall effectiveness | Stop loss orders are effective in limiting potential losses. | Trailing stop orders are effective in protecting profits and potentially maximizing gains. |
Both stop loss and trailing stop orders offer advantages and disadvantages. Traders should carefully consider their risk tolerance, trading style, and market conditions before deciding which type of order to use.
By utilizing trailing stop order, investors can protect their profits and potentially maximize gains while minimizing the risk of selling too late. It's a powerful tool for any investor to have. By automating your exit strategy and giving your trades room to breathe, you can reduce stress. However, it's important to use trailing stop orders wisely and consider their pros and cons before implementing them in your trading strategy.
