When you first start trading, there are certain terms you need to understand to make your trading journey easier. Trailing stop loss is one of these terms.
Trailing stop losses are a combination of trading and risk management techniques. They are sort of profit-protecting stops.
However, a trailing stop loss may occasionally become a curse rather than a benefit. Many novice traders make the error of applying the MT4 trailing stop loss without fully comprehending how it works.
Although trailing stops might lower a trade’s risk, they can also be highly restrictive.
Therefore, consider a trailing stop as an excellent risk management strategy. However, because it is so risk conservative, the profit potential of a trailing stop loss might be significantly reduced.
In this guide, we’ll explain the advantages and disadvantages of trailing stop loss that will help to understand it more clearly.
What is a trailing stop loss?
Before discussing its advantages and disadvantages, it’s important to mention what a trailing stop does.
A stop-loss order is a type of order that helps you control risk by indicating when your trade should be stopped if the price swings against you.
The main advantage of employing a stop-loss is that it limits your losses. Stop-loss orders stay in force until you liquidate your position or cancel the order.
A trailing stop, also known as a trailing stop-loss, is a market order that places a stop-loss at a fraction below an asset’s market price rather than a single number.
Trailing stops allow you to lock in profits while leaving the trade open until the asset’s value reaches the trailing stop level.
How do trailing stops work?
The “Let your profits run; cut your losses short” allows you to follow the ancient trading proverb of “trailing stop.” These trades, as the name implies, lag market prices by a certain amount.
The trailing stop rises upward with the rising market price if your trade is leaning toward profit. As markets move in your favor, the proportion of loss you’re ready to accept stays the same.
If the market finally turns against you, the trailing stop, which has increased in tandem with your profit, preserves your recent profits.
How to set a trailing stop loss?
You can choose a particular number of points or a percentage distance from the initial price for your trailing stop-loss order. Then, the stop-loss order will be activated, and your transaction will be terminated when the market price hits your trailing stop.
Let’s use an example to illustrate this.
If you establish a trailing stop-loss with a distance of 0.50 and the current price is $10, your trailing stop’s trigger price will be $9.5 at first, and every time the asset’s current price increases $0.1, the trailing stop will climb as well, keeping the 0.50 distance.
Using the same example, if the price rises to $10.5, our trailing stop-loss order will rise to $10. This is an example of a trailing stop loss that has been automated. You may also manually establish a trailing stop loss.
More experienced traders prefer the manual trailing stop-loss because it gives them more control over when the stop-loss is changed. The order placed with the brokerage isn’t a trailing stop-loss order in this situation; instead, it’s a regular stop-loss order.
Rather than automating the process, the trader decides when and where the stop-loss order will be moved to mitigate risk.
A trailing stop-loss may be created using indicators, and some are intended particularly for this purpose.
When utilizing a trailing stop-loss based on an indicator, you must manually adjust the stop-loss to reflect the information displayed on the indicator.
The average true range (ATR), which quantifies how much an asset normally moves over a particular time frame, is used in several trailing stop-loss indicators.
Trailing stop loss example
Let’s use a real-world example of a forex pair to illustrate a trailing stop-loss order.
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 intended to be used when you have a profitable trade and want to allow it to continue going in your intended direction while also guaranteeing that if it moves against you, you benefit.
Stops are supposed to safeguard your money, but aggressively putting them close to the price tends to slowly drain your account as you are stopped out over and over.
Remember that trailing stops can only move in your favor; otherwise, they will remain locked at their previous price.
Disadvantages of a trailing stop loss
Now that you know all about trailing stops, let’s discuss what some of the disadvantages of using them are:
Trailing stop losses are hard to determine
Prices will sometimes make a quick, abrupt move that strikes your following stop-loss 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.
There’s no guarantee
It is not guaranteed that you will get the price of your stop-loss order. For example, when asset values decrease rapidly, your order may not be completed at the stop price you specified. This may force you to sell at a lesser price than you anticipated. This is common in fast-moving markets.
Volatility disrupts trailing stop losses
With trailing stop-loss orders, volatile assets may be difficult to trade. If you put an order too low to account for anticipated swings, you will be responsible for large losses.
However, if you place the order too high, you may find yourself selling the asset against your will owing to 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. Still, it is more common during periods of high market volatility, which is exactly when you need a trailing stop loss order to protect you.
Don’t work in all conditions
Because the price is constantly reverting and hitting the following stop-loss during periods when the price isn’t moving well, trailing stop-losses might result in many lost trades.
If this happens, either don’t trade or adopt a set-and-forget strategy. The set-and-forget strategy entails setting a stop and target depending on current market circumstances, then letting the price hit one trading order or the other one without making any modifications.
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 if that’s the case.
Rather than closing the entire position when the market reaches the calculated move, traders book only half of the possible profit, only to have the market reverse and “eat” the other half.
There’s no exact distance
Typical market fluctuations will not trigger a trailing stop set too high, but it implies you’re risking needlessly big losses or giving up more profit than necessary.
Because markets and asset movements are always shifting, there is no such thing as an optimal distance.
Over time, the optimal trailing stop loss will shift. A larger trailing stop is a better bet during more turbulent periods. A tighter trailing stop loss may be useful during calmer times or in a highly steady market. But it can be bothersome for many people.
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.
It doesn’t go well with MT4
You must keep your MT4 trading terminal active in order for the trailing stops functionality from working. The trailing stop function is disabled when the terminal is closed.
One of the drawbacks of using trailing stops in MT4 is this.
Not ideal for day trading and scalping
When day trading or scalping, trailing stops must be used with caution. 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 go wild.
Your trailing stop is most likely to be hit if you place a tight stop close to your price and the price whips back and forth.
Can lead to irrational decisions
Because choices are made in real-time, active trading may be stressful. The trader must make judgments 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 might lead to bad trading judgments.
Are there any advantages of a trailing stop loss?
After reading the cons of trailing stops, you are probably thinking, is there anything good about trailing stop losses? Well, there are many pros to using trailing stops. Here are a few of them:
- If a large trend develops, most of it can be profitably exploited if the trailing stop-loss is not struck throughout the trend. Allowing trades to continue with the trend until they reach the trailing stop-loss, in other words, can result in significant profits.
- If the price rises positively at first but subsequently reverses, a trailing stop-loss is useful. The trailing stop-loss prevents a successful trade from becoming a loser, or at the very least, minimizes the amount of loss if a transaction fails.
- The trailing stop-loss order can be adjusted at any time. For example, you may input any trailing stop-loss % for a personalized risk management plan and adjust it as needed.
- Placing a trailing stop loss order is free of charge.
- This order helps investors to remove emotion from their transactions and focus on predefined objectives instead.
How to place a trailing stop loss like a pro?
Now that you know the pros and cons of a trailing stop loss, here’s how you can set it like a pro.
A trailing stop-loss, for example, may be beneficial when trading a highly volatile currency pair with unpredictable price movements in forex trading. However, keep in mind that higher levels of volatility may cause your stop-loss to be triggered sooner rather than later.
This is why the trailing stop-loss should be placed carefully, taking into account the pair’s past performance as well as market circumstances.
It’s crucial to consider the market’s volatility over a long period, as well as how it acts on a daily basis. For example, putting the stop-loss too near to the market price might lead to an early exit, while setting it too far away would entail risking more money.
If you’re going long (buying a pair), the trailing stop should be put below the current market price. Your trailing stop-loss will be put above the market price if you’re going short (selling).
Trading is difficult, and no ideal solution to the issues listed above exists. When big moves occur, a trailing stop-loss can be quite useful in capturing them. However, if the market isn’t making big swings, a trailing stop-loss may wreak havoc on your performance as tiny losses eat away your money.
Any trailing stop-loss strategy you deploy should be tested in a demo account before using real money. Then, spend several months honing your trailing stop-loss technique and making sure it works.