Prudent risk management is the hallmark of every robust trading strategy. Developing a trading strategy that includes dynamic stop loss levels, allows you to generate strong returns without experiencing undue risks. By incorporating a trailing stop into your trading strategy, you can capture gains that develop with a trend, without giving back what you have already earned.
What is a Trailing Stop Order?
A trailing stop order is a risk management technique where your stop loss level trails the current market level by a specific percent or value. Instead of using a fixed stop price, a trailing stop is a conditional order, that trails an assets price. You can incorporate a sell trailing stop order or a buy trailing stop order which is determined by whether you are long or short a position.
Your broker might allow you to place a trailing stop order that is based on a percent decline in the price from the current price. For example, you can place a sell trailing stop on XYZ stock if the price falls 3% from current levels. Once your trailing stop is triggered it will become a market order that is executed immediately. Since your trailing stop is likely to be a market order, there is no guarantee that you will receive a specific price or price range.
How to Trade with a Trailing Stop Order?
There are several ways to trade a trailing stop order. These types of orders are most effective when you are using a trend following system. Your goal in a trend following system is to capture as much of a trend as possible, without giving back gains when the trend turns.
There are several steps that you should take prior to entering your trade. Prior to initiating a trade with a trailing stop, you should determine your stop loss level. Your stop loss and your trailing stop loss can be at the same level. For example, if you are attempting to generate 6% in returns on a trade, you might initially have a stop loss that is 3% lower than where you purchase your asset.
A trailing stop-loss order works in the following way. If the price of the asset you are trading moves in your favor, you should increase your trailing stop to be 3% lower than the price or exchange rate. For example, if you purchase the USD/JPY at 110, your initial stop loss level could be at 106.7 which is 3% below the entry price. If the price increases to 111, your trailing stop loss would increase to 107.7.
It is important to make sure that your broker not only activates your trailing stop-loss order during liquid trading hours.
There are issues that could occur if you trade when the markets are illiquid. For example, if you have a trailing stop loss in equities during premarket hours, other traders might try to take advantage of the illiquidity and run your stop loss. This would mean your security would trade lower, triggering the loss and then run it the security up again. You can avoid this by only activating your trailing stop during certain trading hours.
In addition to using a percent level to determine your trailing stop loss level, you can also use a currency value or price. A currency value could be the number of dollars or euros you are willing to lose on a trade initially. In the example above, you might be willing to risk $200 to make $600. If this is the case, you would need to back out the price that would act as your initial stop loss and then increase or decrease the price level to generate a trailing stop. You can also use an automatic trailing stop that follows every price level or only use a closing price to calculate the trailing stop trigger.
How do You Calculate the Trailing Stop?
The goal of the trailing stop is to make sure that you catch a trend but do not give back gains that you have already accumulated. The stop can be calculated off the high of a session (if you are long) or the low of the session (if you are short) or the close of the prior session. For example, if the price of USD/JPY increased to a high of a trading session to 115, then your trailing stop should increase to 111.55 (115 * 0.97). If the price on the next day moves down to 114, you would not lower your trailing stop, if you are long USD/JPY. A trailing stop should only move in one direction.
A chart of the USD/JPY shows an example of how to use a trailing stop with a trend following strategy. The strategy generates a sell signal when the 20-day moving average crosses below the 50-day moving average. The entry price is 112.50, and the initial stop loss level is 3% higher than the entry exchange rate which is 115.87. As the price of the USD/JPY declines, the trailing stop loss of 3% is moved lower. There are times such as in early February when the exchange rate of the USD/JPY rebounded, pushing the trailing stop price up. The low price in March was at 104.62, and the trailing stop is triggered at 107.76.
A trailing stop order is a risk management tool that you can use to follow the trend of an asset. By using a trailing stop instead of a targeted take profit level, you can stay with a trend until it begins to reverse. A trailing stop loss replaces a fixed stop price. You can incorporate a sell trailing stop order or a buy trailing stop order which is determined by whether you are long or short a position. You can calculate your trailing stop order using either a percent pullback in prices or a value pullback in prices. You have to find a broker such as FSMSmart that provides to trade with trailing stop-loss orders and instruct your broker as to when your trailing stop is active. Having a trailing stop during illiquid trading hours is not recommended.