A trailing stop loss allows investors to create a built-in safety mechanism to insulate themselves against downward pricing trends. It’s an important exit strategy that day traders can use to manage their risk.
Understanding how a trailing stop order works and how to use it properly can help cap potential losses when day trading investments.
What Is a Trailing Stop Loss?
To understand trailing stop loss, it first helps to understand how limit orders and stop orders work.
A limit order is an order to buy or sell a security once it reaches a specific price. If the order is to buy, it only gets triggered at or below the limit price. If the order is to sell, the order can only get executed at or above the limit price. Limit orders are typically filled on a first-come, first-served basis in the market.
A stop order, also referred to as a stop-loss order, is also an order to buy or sell a particular investment. The difference is that the transaction occurs once a security’s market price reaches a certain point. So for example, if you buy shares of stock for $50 each you might create a stop order to sell those shares if the price dips to $40. Once a stop or limit order is executed, it becomes a market order.
Stop orders help you either lock in a set purchase price for an investment or cap the amount of losses you incur when you sell if the security’s price drops. While you can use them to manage investment risk, stop orders are fixed at a certain share price.
A trailing stop loss, on the other hand, offers a more flexible approach to minimizing investment losses. A trailing stop order trails the price of the underlying investment by a percentage or a specific dollar amount. So using the previous example of buying shares at $50 each, you might impose a trailing stop limit of 10%. If the stock’s share price dipped by 10% they’d be sold automatically.
How a Trailing Stop Order Works
Using a trailing stop to manage investments can help you capitalize on stock market movements and momentum. You determine a preset price at which you want to sell a stock, based on how a particular investment is trending, rather than pinpointing an exact dollar amount.
You can decide where to set a trailing stop limit, based on your risk tolerance and what you expect an investment to do over time. What remains consistent is the percentage by which you can control losses as the investment’s price changes.
So, assume that you purchase 100 shares of stock at $50 each. You set a trailing stop order at 10%. If the share price dips to $45, which reflects a 10% loss, those shares would be sold automatically capping your total loss on the investment at $500.
Now, assume that the stock takes off instead and the share price doubles to $100 with the same 10% trailing stop in place. Your stop order would only be triggered if the stock’s price falls to $90. If you had set a regular stop order at $40 instead, there’d be a much wider margin for losses since the stock’s price has further to fall before shares would be sold. Thus, trailing stops enhanced downside protection compared to a regular stop order.
Advantages of Using a Trailing Stop Orders
There are several benefits that come with using a trailing stop limit to manage your investments. First, trailing stops move in tandem with stock pricing. As a stock’s per share price increases, the trailing stop follows. In the previous example, when the stock’s price doubled from $50 to $90, the trailing stop price moved from $45 to $90.
Implementing a trailing stop limit strategy can offer reassurance since you know shares will be sold automatically if the stop order is triggered. Trailing stop limits rely on math rather than emotions when making decisions. That can also help you avoid the temptation to try to time the market and either sell too quickly or hold on to a stock too long, impacting your profit potential.
How Do You Set up a Trailing Stop Order?
If you’re day trading online, it’s relatively simple to set up a trailing stop loss order for individual securities. Because the orders are flexible, you can choose where you want to set the baseline percentage at which stocks should be sold. For example, if you’re less comfortable with risk you might set a trailing stop at 5% or less. But if you’re a more aggressive portfolio, you may bump the order up to 20% or 30%.
You can also control whether you want buy or sell actions to happen automatically or whether you want to place trades manually. Automating ensures that the trades happen as quickly as possible, but performing them manually may be preferable if you’re more of a hands-on trader.
Are There Any Downsides of Using a Trailing Stop?
Investing is risky, by nature and no strategy is foolproof. While trailing stops can help minimize losses without placing a cap on profits, there are some downsides to consider.
Depending on which online brokerage you’re using, you may face limits on which investments you can use trailing stop loss strategy with. Some online brokerages don’t allow any type of stop loss trading at all.
Potential to Lock in Losses
If a stock you own experiences a two-day slide in price, your stop loss order might require your shares be sold. If on the third day, the stock rebounds with a 20% price increase, you’ve missed out on those gains and locked in your losses. If you want to repurchase the stock you’ll now have to do so at a higher price point, and you’ve missed your chance to buy the dip.
If share prices drop too quickly there may be some lag time before your trailing stop order can be fulfilled. In that scenario, you might end up incurring bigger losses than expected, regardless of where you placed your stop price limit.
How to Use a Trailing Stop Loss Strategy
Using trailing stops is better suited as part of a short-term trading strategy, rather than long-term investing. Buy-and-hold investors focused on value don’t need to worry as much about day-to-day price movements.
With that in mind, there are a few things to consider before putting trailing stop orders to work. A good starting point is your personal risk tolerance and the level of loss you’d be comfortable accepting in your portfolio. This can help determine where to set your trailing stop loss limit.
Again, if you’re a more conservative investor then it might make sense to set the percentage threshold lower. But if you have a larger appetite for risk, you could go higher. You can also tailor thresholds to individual investments to balance out your overall risk exposure.
Becoming familiar with technical indicators could help you become more adept at reading the market so you can better gauge where to set trailing limits. Unlike fundamental analysis, technical analysis primarily focuses on decoding market signals regarding trends, momentum, volatility and trading volume.
This means taking a closer look at a security’s price movements and understanding how it’s trending. One indicator you might rely on is the Average True Range (ATR). The ATR measures how much a security moves up or down in price on any given day. This number can tell you where to set your trailing loss limit based on whether price momentum is moving in your favor.
In addition to ATR you might also study moving averages and standard deviation to understand where a stock’s price may be headed. Moving averages reflect the average price of a security over time while standard deviation measures volatility. Considering these variables, along with your risk tolerance and overall investment goals, can help you use trailing losses in your portfolio correctly.
Whether you plan to use trailing stop strategies in your portfolio or not, making sure you’re working with the right brokerage matters. Ideally, you’re using an online brokerage that offers access to the type of securities you want to invest in with minimal fees so you can keep more of your portfolio gains.
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