Trailing Stop Order: Lock In Profits & Limit Losses
Overview
A trailing stop order is a strategic trading tool designed to help investors protect their gains and limit losses without constant market monitoring. Unlike a fixed stop-loss order, a trailing stop automatically adjusts the stop price as the security’s market price moves favorably, locking in profits while allowing room for further growth.
What is a Trailing Stop Order?
At its core, a trailing stop order is a type of stop-loss order that moves with the market price. You set a trailing amount—either a percentage or a fixed dollar value—and the stop price adjusts only in the direction that benefits you.
- If the price rises, the stop price moves up, maintaining the set distance.
- If the price falls, the stop price stays in place.
This mechanism helps you secure profits by “trailing” the highest price reached since placing the order. If the price drops by the trailing amount, the order triggers to sell (or buy), protecting your position.
How Does a Trailing Stop Order Work?
For example, if you buy a stock at $50 and set a 10% trailing stop-loss:
- Initial stop price is $45 ($50 – 10%).
- If the stock price rises to $60, the stop price adjusts up to $54 (10% below $60).
- If the price then falls to $53, the stop triggers a sale near $53, locking in at least a $3 profit per share.
This automated adjustment allows you to benefit from upward price movement while managing downside risk.
Why Use a Trailing Stop Order? The Benefits
- Lock in profits: Automatically secures gains as the price rises.
- Limit losses: Offers downside protection by setting a dynamic floor.
- Reduce emotional trading: Automates exit decisions, preventing impulsive reactions.
- Enable growth: Allows trades to run longer during favorable trends.
- Flexible settings: Choose percentage or dollar-based trailing amounts to match your strategy.
Types of Trailing Stop Orders
- Trailing Stop-Loss (Sell Stop): Most common. Used to sell a security if it falls by the trailing amount from its highest price.
- Trailing Stop-Buy (Buy Stop): Used to buy securities if the price rises by the trailing amount from its lowest price, often to enter upward breakout trades.
Who Should Use Trailing Stop Orders?
- Active traders: Manage risk and maximize profits in short- to medium-term trades.
- Long-term investors: Protect gains on appreciated holdings without constant monitoring.
- Options traders: Manage leveraged positions with dynamic stops.
How to Set the Right Trailing Amount
Choosing the proper trailing amount involves balancing risk tolerance and market volatility:
- Use wider trails for volatile stocks to avoid premature triggers.
- Use tighter trails for stable stocks or short-term trades.
- Avoid setting the trail too tight (may lead to early exits) or too wide (may give back profits).
- Use technical tools like the Average True Range (ATR) to gauge volatility.
Trailing Stop Orders vs. Other Order Types
- Stop-Loss: Fixed price order; doesn’t adjust with market gains.
- Trailing Stop: Dynamic, adjusts with favorable price moves.
- Limit Order: Guarantees price but not execution.
- Trailing Stop-Limit: Combines trailing stop with limit order; can risk not executing if price gaps.
Common Mistakes and Misconceptions
- Trailing stops don’t guarantee selling at the stop price, especially in fast markets.
- Setting the trailing amount too tight or too wide can undermine effectiveness.
- Trailing stops can be used for buying, not just selling.
Examples
- Protecting Gains: Buying stock at $100, setting a 15% trailing stop. As price climbs to $150, the stop rises to $127.50, locking in $27.50 gains if price drops.
- Entering Trades: Setting a $3 trailing stop-buy on a $35 breakout. The buy price moves up with the stock, executing when price surpasses the trailing stop, capturing momentum.
FAQs
Q: What’s the difference between trailing stop and trailing stop-limit?
A: Trailing stop executes a market order when triggered, while trailing stop-limit places a limit order, which may fail in fast markets.
Q: Can trailing stops be used on all securities?
A: Mostly available for stocks, ETFs, and some options, but availability varies by broker.
Q: What if price gaps below my stop?
A: Market orders fill at the next available price, which can be lower than stop price. Limit orders may not execute if price gaps past limit.
Conclusion
Trailing stop orders offer investors and traders an automated way to manage risk, protect profits, and participate in market gains without constant oversight. Proper understanding and application of trailing stops can enhance portfolio returns and support disciplined trading strategies.
Sources
- Investopedia: Trailing Stop Order
- SEC: Investor Education on Stop and Limit Orders
For more insights on stop orders, check out our Stop-Loss Order explained.