What Is a Trailing Stop Order?
A trailing stop order is a type of order used in trading that allows traders to set a stop loss at a certain percentage or dollar amount below the market’s most recent high price. Unlike a regular stop loss order, which remains fixed at a certain price level, a trailing stop order adjusts the stop loss level as the market price moves in the trader’s favor. The stop loss level “trails” the market price at a predetermined distance, which is often expressed as a percentage or dollar amount.
Trailing stop orders are typically used to lock in profits while allowing for potential further gains. If the market price moves against the trader, the trailing stop order will trigger a sale at the stop loss level, limiting the trader’s losses.
Pros and Cons of Trailing Stop Orders
Trailing stop orders can be a useful tool for traders to manage risk and lock in profits. Here are some of the pros and cons of using trailing stop orders:
Pros:
- Automatic adjustment: Trailing stop orders automatically adjust the stop loss level as the market price moves in the trader’s favor, which can help lock in profits while allowing for further gains.
- Flexibility: Trailing stop orders can be set at a specific percentage or dollar amount, allowing traders to tailor their stop loss level to their specific trading strategy.
- Risk management: Trailing stop orders can help manage risk by providing an automatic stop loss level that limits the trader’s losses.
- Hands-off approach: Trailing stop orders allow traders to step away from the market and still have a stop loss order in place.
Cons:
- Vulnerable to market gaps: Trailing stop orders may not protect against market gaps or sudden price movements, which can result in slippage or execution at a worse price than intended.
- Complex execution: Trailing stop orders can be complex to execute, as traders must consider the distance and percentage of the trailing stop.
- Execution delays: Trailing stop orders may be subject to execution delays in fast-moving markets, which can result in slippage or execution at a worse price than intended.
- Over-reliance: Traders may become over-reliant on trailing stop orders and fail to monitor the market, which can result in unexpected losses.
Overall, trailing stop orders can be a useful tool for managing risk and locking in profits, but traders should be aware of the potential risks and execute these orders carefully. It is important for traders to monitor the market and adjust their trailing stop orders as needed to ensure they align with their trading strategy.
Trailing Stop Order Examples
Here are a couple of examples to illustrate how trailing stop orders work:
- Stock Example: Let’s say a trader purchases a stock at $100 and sets a trailing stop order with a 10% distance. If the stock price rises to $110, the stop loss level will be adjusted to $99 ($110 minus 10%). If the stock price then rises to $120, the stop loss level will be adjusted to $108 ($120 minus 10%). If the stock price falls to $108 or below, the stop loss order will be triggered and the trader’s position will be sold.
- Cryptocurrency Example: Let’s say a trader buys Bitcoin at $50,000 and sets a trailing stop order with a 5% distance. If the price of Bitcoin rises to $55,000, the stop loss level will be adjusted to $52,250 ($55,000 minus 5%). If the price of Bitcoin continues to rise to $60,000, the stop loss level will be adjusted to $57,000 ($60,000 minus 5%). If the price of Bitcoin falls to $57,000 or below, the stop loss order will be triggered and the trader’s position will be sold.
These examples demonstrate how a trailing stop order can adjust the stop loss level as the market price moves in the trader’s favor, which can help lock in profits while allowing for further gains. Traders can use trailing stop orders with any asset, including stocks, cryptocurrencies, commodities, and more.
Trailing Stop Order vs. Market Stop Order
The main difference between a trailing stop order and a market stop order is that a trailing stop order adjusts the stop loss level as the market price moves in the trader’s favor, while a market stop order is triggered when the market price reaches a specific level. Trailing stop orders are designed to help traders lock in profits while allowing for further gains, while market stop orders are designed to limit losses by exiting the position at a predetermined price level.
The Bottom Line
Trailing stop orders are useful for traders who want to limit their losses while allowing their profits to run, and they can be particularly effective in volatile markets where prices can move quickly. However, it’s important to note that trailing stop orders do not guarantee that a trader will make a profit, and they can also be subject to slippage if the market price moves quickly. As with any trading strategy, it’s important to carefully consider the risks and benefits before using a trailing stop order.
