Trailing Stop Loss: How to Use it Effectively?

Modern trading platforms offer a variety of order types designed to meet different trading needs, from simple market orders to advanced stop-loss strategies. Among these, the trailing stop loss stands out as a flexible and dynamic tool that adjusts automatically with price movements.

What is a Trailing Stop Loss?

A trailing stop loss is a type of order that helps traders manage risk while allowing profits to grow by keeping the position open. Unlike a standard stop-loss order, it adjusts automatically as the market price moves in your favor. This makes it a dynamic tool for locking in profits.

Let’s break it down with 2 examples:

Long Position Example

Imagine you’re trading XYZ stock at a current price of $100 per share. You set a trailing stop loss with a distance of $5. Here’s how it works in different scenarios:

In this example, the trailing stop ensures that if the price rises to $110, your stop-loss follows to $105, locking in at least $5 per share in profit. If the price falls to $104, the stop-loss activates, automatically selling the position at $105.

Short Position Example

Imagine you short ABC stock at a current price of $200 per share. You set a trailing stop loss with a distance of $10. 

Here’s how it works:

• If the price drops from $200 to $180, your stop adjusts downward from $210 to $190, locking in $10 per share in profit.
• When the price rebounds to $191, the stop activates, closing your position at $190.

How Does a Trailing Stop Loss Work?

The idea is simple: lock in profits as the price moves in the desired direction while limiting losses if the price reverses. 

The key feature of a trailing stop is that it follows the price only in the favorable direction and remains fixed if the price moves against you.

Key Features

• Dynamic Adjustment: The stop-loss level moves with the market price, maintaining a set distance.
• One-Way Movement: It only adjusts when the price moves in your favor; it doesn’t move if the price goes against you.
• Automatic Execution: If the market hits the stop-loss level, the trade is automatically closed.

Trailing Stop Examples in Forex Transactions

Let’s see how this works with both a long position and a short position:

Example: Long Position in EUR/USD

• Entry Price: 1.1200
• Account Balance: $5,000
• Leverage: 1:200
• Position Size: 1 lot (100,000 units)
• Stop Distance: 30 pips
• Action: The trailing stop starts at 1.1170 and adjusts upward as the price rises.

Scenario Explanation:

1) Initial Setup (1.1200):

• The trade starts with a trailing stop at 1.1170.
• No profit or loss is locked yet.

2) Price Rises to 1.1250:

• The trailing stop adjusts upward to 1.1220.
• The current profit is $500.
• The locked profit is $200 (1.1250 - trailing stop at 1.1220).

3) Price Pulls Back to 1.1230:

• The trailing stop remains at 1.1220.
• The current profit drops to $300.
• The locked profit stays fixed at $200.

4) Trade Closes at 1.1220 (1.1215 Hit):

• The trailing stop triggers at 1.1220.
• The trade closes with a current and locked profit of $200.

Example: Short Position in TESLAUS

• Current Price: $421
• Entry Price: $421
• Account Balance: $10,000
• Leverage: 1:20
• Position Size: 5 shares
• Stop Distance: $5

Scenario Explanation:

1) Initial Setup ($421):

• The trailing stop is set at $426 (5 points above the entry).
• No profit or loss is locked yet.

2) Price Drops to $416: 

• The trailing stop adjusts downward to $421.
• Current P/L: $25 (based on the price drop).
• Locked P/L: $25 (trailing stop secured this amount).

3) Price Rebounds to $418:

• The trailing stop remains fixed at $421.
• Current P/L: $15 (price is closer to the stop).
• Locked P/L: $25 remains unchanged.

4) Price Hits $422:

• The trailing stop triggers at $421, closing the trade.
• Current P/L: $0 (as price returned to entry).
• Locked P/L: $25 (secured profit is retained).

When Should You Use a Trailing Stop?

A trailing stop acts as a flexible safety net for your trades, adapting to market conditions and your goals. Set it too tight, and regular market noise might stop you out too soon. Set it too loose, and you could end up giving back a big chunk of your gains.

Trending Markets

This order type is highly effective in trending markets. When prices are steadily moving in one direction, a trailing stop allows you to capture the bulk of the trend while limiting your downside. This is particularly helpful when trading instruments like gold or major currency pairs, where sustained trends often occur following key market events.

Volatile Conditions

Markets driven by news, such as central bank announcements or earnings reports, can create sharp price movements. Trailing stops can help you navigate such volatility by locking in profits as prices surge, helping you benefit from the momentum without exposing yourself to a sudden reversal.

Swing or Long-Term Trades

For traders holding positions for several days or weeks, trailing stops provide a safeguard against unexpected market reversals. Instead of constantly monitoring your trades, it automates the process, protecting your gains and allowing you to focus on other opportunities.

Avoiding Emotional Decisions

One of the biggest advantages of a trailing stop is its ability to remove emotions from the equation. It enforces discipline by automating your exit strategy, preventing you from second-guessing or holding onto positions longer than you should. This is especially important in instruments like Tesla stock or Bitcoin, where emotions can easily cloud judgment due to their high volatility.

Dynamic Market Conditions

Markets are rarely static, and a trailing stop adapts to changes in price action. Whether you’re trading forex pairs like GBP/USD or commodities like crude oil, a well-set trailing stop allows you to ride the wave of market momentum while keeping your risk in check.

FAQs on Trailing Stop Loss

What is the difference between a trailing stop loss and a trailing stop limit?

A trailing stop loss triggers a market order when the price moves against you by the specified trailing amount, ensuring your trade closes at the next available price. A trailing stop limit triggers a limit order, meaning the trade will only close at your specified price or better, which can be risky in fast-moving markets.

How do I set the right trailing distance?

The ideal trailing distance depends on the instrument's volatility and your trading strategy. For volatile assets like Bitcoin, use a wider distance to avoid premature stop-outs. For less volatile instruments like gold, a tighter trailing distance may suffice. Testing and adjusting are key.

Can I use it in all markets?

It can be used in most markets, including forex, stocks, and commodities. However, their availability depends on the platform you’re using. Tools like MetaTrader 5 and cTrader support trailing stop functionality, making it easy to apply across various instruments.

When should I avoid using a trailing stop?

Avoid using it in sideways or range-bound markets where prices frequently oscillate. In such cases, a fixed stop-loss or manual monitoring might be more effective to prevent unnecessary exits due to minor fluctuations.

Does a trailing stop guarantee a specific exit price?

No, it does not guarantee a specific exit price. It executes at the next available market price once triggered. In highly volatile markets, slippage may occur, causing the actual exit price to differ from your intended stop level.