Starting out in trading requires an understanding of key terms, such as trailing stop loss, to make the journey smoother. Trailing stop losses combine trading and risk management techniques to protect profits. However, novice traders often misuse the tool, resulting in limitations.
While trailing stops can lower risk, they can also restrict profit potential. It’s important to consider them as a risk management strategy but keep in mind that they may reduce profit potential. In this guide, we’ll outline the pros and cons to help you gain a clearer understanding of the strategy.
What is a trailing stop loss?
Understanding how a trailing stop works is critical to managing risk and maximizing profits in trading. A stop-loss order is a fundamental risk management tool used to prevent losses by specifying when a trade should be closed if the price moves against you. The primary benefit of a stop-loss is the ability to limit losses, ensuring that you don’t lose more than you’re willing to risk. These orders remain active until the position is liquidated or the order is canceled.
A trailing stop, on the other hand, is a more sophisticated tool that combines trading and risk management techniques to optimize profits. A trailing stop-loss is a type of market order that sets a stop-loss at a percentage below the market price of an asset, rather than a fixed number. By trailing the stop loss at a specific percentage below the market price, traders can lock in profits while leaving the trade open until the asset’s value reaches the trailing stop level. This means that if the asset’s price rises, the stop will automatically adjust to the new higher price, ensuring that profits are locked in, and the trade is closed if the price drops back to the stop level.
While such kind of stops have significant advantages, they can also be restrictive if used incorrectly. Novice traders may misuse trailing stops by applying them without fully comprehending how they work, which may result in limitations to their trading strategies. Additionally, trailing stops are highly risk-averse, which means that the profit potential of a stop loss may be significantly reduced.
In summary, a trailing stop is a valuable tool for traders, but it’s important to understand its pros and cons. By using it, you can maximize profits while managing risk effectively, but it’s crucial to apply the tool correctly to avoid unnecessary limitations to your trading strategies.
How do trailing stops work?
The age-old trading proverb of “let your profits run, cut your losses short” can be effectively followed by using the trailing stop technique. As the name suggests, orders trail the market prices by a specific amount.
When you use a this stop type, it rises along with the market price when your trade is in profit. This means that as the market moves in your favor, the proportion of loss you are willing to accept remains constant.
If the market eventually turns against you, the trailing stop, which has increased in proportion to your profit, helps to safeguard your recent gains. By using them, you can maximize your profits while limiting your losses, which is an essential aspect of successful trading.
How to set a trailing stop loss?
To start using this stop-loss order type, you should set a specific number of points or a percentage distance from the initial price. When the market price hits your trailing stop, the stop-loss order will be triggered, and your transaction will be terminated.
Here’s an example to help you understand how it works. Suppose you set a stop-loss distance of 0.50 with a current price of $10. In that case, the trigger price for your trailing stop will be $9.5 initially. As the asset’s current price increases by $0.1, the stop will also rise while keeping the 0.50 distance.
Using the same example, when the price rises to $10.5, our stop-loss order will rise to $10. This is an instance of an automated stop loss. Alternatively, you can also establish a manual adjustment stop loss.
Some traders prefer trail the stops manually as it offers them more control over when the stop-loss is adjusted. In this case, the order placed with the brokerage isn’t a trailing stop-loss order, but a regular stop-loss order.
Using the Trade Panel to set up a trailing stop-loss has several advantages over manually setting a stop-loss. Firstly, it saves time and effort as the trader doesn’t have to monitor the market continuously. The Trade Panel automates the process, which allows traders to concentrate on other aspects of trading, such as analyzing market trends and making trading decisions.
Additionally, the Trade Panel allows traders to customize their stop-loss settings according to their risk management plans. This feature helps traders to have a more structured approach to trading, which can result in better risk management and improved profitability. Overall, using the Trade Panel for trailing stop-losses can save time, reduce stress, and improve trading performance.
Trailing stop loss example
Let’s use a real-world example of a forex pair to illustrate this stop-loss order type.
Placing a 50-pip trailing stop on EUR/USD after buying it at 1.1850 means that if the price climbs to 1.1900, your stop will move from 1.1800 to 1.1850. (50 pips).
Unless the market rises another 50 pips in your favor, your stop will remain at 1.1850. This implies that your trade will be open as long as the price does not move 50 pips against you.
Should you use a trailing stop loss?
Trailing stops are a useful tool when you have a winning trade and want to keep it going in the direction you intended while also securing your gains in case it turns against you.
Although stops are intended to protect your capital, placing them too aggressively near the price can gradually deplete your account as you get stopped out repeatedly.
It’s essential to keep in mind that trailing stops can only move in your favor; if the market moves against you, the stop will remain fixed at its previous level.
Disadvantages of a trailing stop loss
Trailing stops have become a popular strategy among traders, and for good reason. They allow you to protect your gains in a profitable trade by locking in profits as the price moves in your favor. However, like any strategy, trailing stops come with their own set of drawbacks and limitations that traders need to be aware of. In this response, we’ll discuss some of the disadvantages of using trailing stop loss orders.
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Trailing stop losses are hard to determine
One of the biggest challenges of using trailing stops is determining the right distance to place your stop order. If you set it too far away, you risk losing a significant portion of your profits if the price suddenly reverses. On the other hand, if you set it too close, you risk getting stopped out prematurely in a volatile market.
Furthermore, prices can sometimes make a quick, abrupt move that triggers your trailing stop loss order but then continue in the desired direction without you. If you hadn’t modified the original stop-loss with a trailing order, you might still be in the trade and profiting from positive price movements.
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There’s no guarantee
Another issue with trailing stops is that there’s no guarantee that you’ll get the price of your stop-loss order. In fast-moving markets, such as during periods of high volatility, the asset value can decrease rapidly, and your order may not be executed at the stop price you specified. This can force you to sell at a lower price than you anticipated, resulting in a loss.
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Volatility disrupts trailing stop losses
Trailing stop-loss orders can be particularly challenging to use with volatile assets. If you set the order too low to account for anticipated swings, you risk suffering large losses. However, if you set it too high, you may end up selling the asset against your will during natural market fluctuations at a time when it would be preferable to keep it.
Gapping is a term used to describe a situation in which the price of your asset passes through the price of your trailing stop loss order without you being sold out. Gapping can occur at the market opening when the price starts significantly lower than it closed the night before, but it is more common during periods of high market volatility. This is exactly when you need a trailing stop loss order to protect you.
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Trailing stops don’t work in all conditions
Trailing stops can result in many lost trades during periods when the price isn’t moving well. When this happens, traders can choose to either not trade or adopt a set-and-forget strategy. The set-and-forget strategy involves setting a stop and target depending on current market circumstances and then letting the price hit one trading order or the other one without making any modifications.
Moreover, the forex market is known to trade in ranges for over sixty or sixty-five percent of the time. Therefore, trends like the one shown here on the EURUSD don’t happen very often. Trailing stops won’t assist in such cases. Rather than closing the entire position when the market reaches the calculated move, traders may book only half of the possible profit, only to have the market reverse and “eat” the other half.
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There’s no exact distance
The optimal distance for a trailing stop loss is constantly shifting because markets and asset movements are always changing. A larger trailing stop is a better bet during more turbulent periods, while a tighter trailing stop loss may be useful during calmer times or in a highly steady market. However, it can be frustrating for traders to constantly adjust their trailing stop orders based on market conditions.
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Accessibility
Depending on the online brokerage you use, the investments you may employ a trailing stop loss strategy with may be limited. Some online brokerages do not enable stop-loss trading at all. Therefore, traders should research and find an online brokerage that allows for trailing stop-loss orders to be placed.
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Manual adjustment in MT4 and MT5
If you use the MetaTrader 4 or MetaTrader 5 trading platforms, you must adjust the trailing stops manually. However, in TradingKit we have developed a Trade Panel that can do the work for you. It has various settings for trailing stop losses and helps a lot to simplify the trading routine.
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Not ideal for day trading and scalping
Trailing stops must be used with caution when day trading or scalping. Currency pairs can cycle up and down before moving in their final direction in the forex market, which is known as whipsaw. This becomes more important when you are a scalper because you have to make trading decisions quickly, and the price can be volatile. If you place a tight stop close to your price and the price whips back and forth, your trailing stop is most likely to be hit.
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Can lead to irrational decisions
Active trading can be stressful as traders must make decisions in real-time with each price change. Should you stay or should you leave? Is it possible to move the trailing stop? Do you want to change the profit target? Because discipline, like a muscle, may get exhausted under such stress, it can lead to bad trading judgments.
In conclusion, while trailing stops can be useful in certain situations, they also have several disadvantages that traders should be aware of. It is essential to understand how trailing stops work and the conditions under which they are most effective. Traders should also have a solid trading plan and risk management strategy in place before using trailing stops to help minimize their risks.
Are there any advantages of a trailing stop loss?
Despite the disadvantages mentioned earlier, there are numerous advantages to using trailing stops as a risk management tool in trading. Let’s take a closer look at some of them:
- Profit maximization: When trailed, stop losses can allow traders to capture more profit during large trends. By allowing trades to continue with the trend until they reach the trailied stop-loss, traders can lock in profits and take advantage of a potentially significant market movement.
- Risk reduction: Trailing stop losses can also be useful in minimizing potential losses in the event of a trend reversal. By trailing the stop-loss as the price moves in the trader’s favor, a successful trade can be prevented from becoming a loser or, at the very least, the amount of loss can be minimized.
- Flexibility: Stop-loss orders can be trailed at any time, giving traders the flexibility to customize their risk management plan according to their trading strategies and objectives. Traders can also adjust the trailing stop-loss as market conditions change.
- Cost-effective: Placing any stop-loss including trailing one is free of charge, making it an affordable risk management tool for traders.
- Emotional control: By using a trailing stop-loss order, traders can remove emotions from their trading decisions and focus on their predefined objectives. This can help traders make more rational decisions and avoid impulsive actions that could lead to unnecessary losses.
In summary, while there are some disadvantages to using trailing stops, the benefits of this risk management tool make it a valuable addition to any trader’s arsenal.
How to place a trailing stop loss like a pro?
If you want to set a trailing stop-loss like a pro, it’s important to consider a few factors.
First, you should assess whether this kind of a stop-loss is appropriate for the currency pair you are trading, particularly if it is highly volatile with unpredictable price movements. However, keep in mind that increased volatility could lead to the stop-loss being triggered earlier than anticipated.
To place the trailing stop-loss effectively, you should carefully evaluate the pair’s past performance as well as current market conditions. It’s important to consider the market’s volatility over a longer time frame, as well as its daily behavior. Setting the stop-loss too close to the market price may result in an early exit, while placing it too far away could increase your risk exposure.
If you’re buying a pair, you should place your trailing stop-loss below the current market price. Conversely, if you’re selling, the stop-loss should be placed above the market price. By following these guidelines, you can help to manage your risk and potentially maximize your profits when using a trailing stop-loss.
Professional traders often focus on making trading decisions rather than spending time on routine tasks such as manually managing trades. This is why they rely on software like Trade Panel to automate these activities and allow the program to handle them. Another helpful tool is the Risk Manager, which can also control risks and stops and keep risk management under control. By using these tools, traders can free up their time and energy to focus on making more informed and profitable trading decisions.
Final thoughts
In conclusion, using a trailing stop-loss is a popular strategy in trading, but it comes with its own set of advantages and disadvantages. It can be useful in capturing big market moves, but it may also result in losses during times of low volatility.
To use this strategy effectively, it is essential to carefully consider the market conditions and the appropriate placement of the stop-loss order as well as automate it using software like Trade Panel. It is also crucial to test any trailing stop-loss strategy in a demo account before implementing it in a live trading environment. With practice and experience, traders can develop a successful trailing stop-loss strategy that fits their trading style and risk management plan.