What is Trailing Stop Loss and how to use it?
A trailing stop loss order is a type of order that allows the trader to capitalize on the gains from a trade when it moves in the direction of the trade. At the same time, a trailing stop order is triggered and automatically closed when the trade reverses by a specified number of pips or ticks.
A trailing stop is nothing but a stop loss order. The difference however is that it is more dynamic. Once a trailing stop order is set, a trader does not need to intervene. There are obviously a lot of advantages in using a trailing stop order.
However, not many traders know about how to use a trailing stop order. Typically, you can find that many traders and even trading signal providers tend to use fixed stop loss orders.
In this article, you will learn what a trailing stop order is and how to effectively use it in your trading. You will also learn about some of the disadvantages of using the trailing stop order as well.
How is a trailing stop loss order different from a fixed stop loss order?
A fixed stop loss order is where the trader enters a price. When the market hits this price, the stop loss order is triggered and the trade is exited.
For example, if you were to take a long position in EURUSD with your entry price at 1.1400 with a stop loss at 1.1350 and target at 1.1600, then if the EURUSD falls to 1.1350, your long position would be liquidated and your trade would be closed.
This is how a fixed stop loss order works. As you can see, it is relatively simple.
A trailing stop order works in the same way (i.e. your trade will be liquidated if the trailing stop price is hit). However, this is where the difference ends. Unlike a fixed stop loss level, a trailing stop continues to trail the order thus ensuring that some profits are locked in.
A trailing stop loss order is used in almost every market, provided that your broker allows this functionality. Furthermore, your trading platform should also be able to offer you this function.
How does a trailing stop loss order work?
The best way to understand a trailing stop order is by an example.
Let's say you have a long position in EURUSD at 1.1400, stop loss order at 1.1350 and your target take profit order at 1.1600.
When a trailing stop loss order is set, you do it by specifying the number of ticks. On the MT4 trading platform, a trailing stop loss order can be set from the order window.
Simply right click on the open trade and select “Trailing Stop”
The picture below shows how to enable the trailing stop feature on the MT4 trading platform.
Trailing stop order feature on the MT4 platform
In the above picture you can see that you can select the trailing stop order based on a default set of points or pips or you can also choose a custom option and set the number of pips yourself.
Note that the points refer to the fifth decimal. Thus, a 50 point trailing stop is nothing but a five pip trailing stop loss order.
Going back to our example, if we set a trailing stop order of 100 points (or 10 pips) it means that if price falls by 10 pips or more, your trailing stop order is automatically closed out.
So, if EURUSD rose from 1.1400 to 1.1420, then the trailing stop order would move to 1.1410. If EURUSD continues to move higher to 1.1495, then the trailing stop order is moved from 1.1410 to 1.1485. Now, if EURUSD reversed and fell to 1.1485 or less, your long position would be automatically closed out as your trailing stop order would sit at 1.1485.
What are the pros and cons of using a trailing stop order?
The benefit of using a trailing stop order is quite straight forward. When price runs in your favor or in the direction of the trade, a trailing stop order can significantly protect the profits. In other words, a trailing stop order does not leave any meat on the table.
However, to the flipside, a trailing stop order can result in a premature exit from your trade. Because seldom moves in a straight direction, a trailing stop order can get your trade to be exited prematurely. Therefore, while you were aiming for a 100 pip move, a trailing stop order could get your trade closed only for 50 pips.
Still, compared to a fixed stop loss order, a trailing stop is a better solution in some cases.
Trailing stop loss in the share market is also widely used. However, investors can either choose the number of ticks or simply set a percentage move. So, if a trailing stop loss of 10% is set, then if price of the stock falls by 10%, the trailing stop loss is automatically triggered.
A trailing stop is probably one of the easiest ways to protect one’s profits while trading. However, make sure that you use the trailing stop wisely. Choosing too tight a trailing stop can result in premature closure of the trades.
However, choosing too wide a trailing stop order could result in having to wait endlessly until price moves in your favor for the trailing stop to kick in.