Trailing Stop Loss: What It Is and How to Use it

Written by Parker PopeUpdated: 21st Aug 2021
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The markets are extremely volatile, and it only seems to be getting more so as time moves on.

Individual investors have several tools at their disposal to protect positions from losing money. At the end of the day, that’s the first rule of trading – don’t lose.

However, if you’re already seeing profits, that volatility mentioned above might hit you if you don’t employ the right tools to protect your winning positions.

Let’s talk a bit about the stop loss. You might need to implement it to save your profits and avoid letting a winning position turn around on you.

What Is a Trailing Stop Loss?

If you’re an intra-day trader, you probably already know what a stop-loss order is. Ideally, every order should come with one of these because it will take you out quickly if your original theory turns out to be wrong. This will keep you from losing too much money.

On the other hand, a trailing stop loss is a way to protect a position that is already profitable. 

Simply put, a trailing stop loss is a stop-loss order adjusted closer to the current price in a position showing profits.

How Does a Trailing Stop Loss Work?

When you enter a position as an intra-day trader, you want a trade to break even as quickly as possible. Ideally, you have a stop order as part of a bracketed entry to limit your losses.

Once a position shows a profit, you can move your stop to just above break-even and guarantee no losses on the trade. 

As price continues to show profits, you can keep moving the stop up as many times as you want. 

This will keep locking in profits as the price continues up (or down, if you’re short).

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Trailing Stop Loss Example

Let’s say that you are trading our good friend stock XYZ.

If you buy the stock at $100.00 with a stop loss at $90.00, the risk on a single share position is $10.

If the stock takes off and hits $110.00, you could certainly sell and enjoy your riches. 

An alternative is the trailing stop loss. Adjust your stop order to $101.00 to guarantee you won’t lose on the position.

If the stock hits $120, you might move your stock order up to $110.00, thereby guaranteeing $10 profit on the position.

But XYZ just won’t quit!  It moves up to $150. After giving yourself a high five, you may want to move your stop up to $125 and guarantee at least $25 profit on the trade.

This could go on forever, but eventually, the stock turns around. Let’s say after $150, the stock takes a dump and goes back to $110. Well, you still have your $25 in profit.  This was a successful trailing stop loss.

How Do You Use a Trailing Stop Loss?

Remember that a successful trailing stop loss is based on a plan that you implement the same way every time. If you’re a technical trader, you’ll want to specify in your trade plan what this means.

You can certainly adjust your stop order as many times as you want, assuming your platform allows it. However, stock prices are unpredictable and could reverse without warning.

Making the decision about where your stop order gets moved to as simple as possible will be a huge benefit to you in the long run. 

After all, the less time you spend deciding how to manage a position, the more time you get to go find that next one.

On most platforms, the actual execution of a stop order is usually quite simple. You select your stop order and click whatever variation you have of “modify.” Then, you enter in the new price at which you want your stop order to be executed.

After confirming your adjustment, that’s it! Simple!

What Are the Advantages to Using a Trailing Stop Loss?

The advantage of a well-executed trailing stop loss order will usually result in more consistent profits across the board. 

Assuming you have a strategy that puts you in positions that should prove to be profitable over the long term, you can at least reduce your losing positions by making them break-even positions.

What Are the Disadvantages to Using a Trailing Stop Loss?

As we said, the stock market is unpredictable, no matter how “bulletproof” our strategies are.

The downside of a trailing stop loss or, indeed, any stop loss is that you might have been right, but the stop took you out just a bit too soon.

Stocks, especially those that are less liquid, tend to gap up or down in response to major market events.

If your stop is inside of the gap, you will get immediately filled at the nearest price upon market open. This could be far more of a loss than you anticipated. 

When you get filled way beyond your original parameters, this is called slippage. Trailing stops may not get triggered if the price reverses with much more enthusiasm than you were expecting.

Why Should You Use Trailing Stop Loss Orders?

Regardless of your strategy and stock picks, trailing stop losses are a good management strategy to implement, but you need to have a set plan that dictates how they are executed.

When Should You Use a Trailing Stop Loss?

Trailing stop-loss orders should be either used on every profitable position or not at all. Again, a well-executed trailing stop loss strategy should be a part of their plan for each position you enter.

It’s really a matter of ensuring consistency than anything else. If you don’t use it as part of a strictly followed plan, you risk the chance that you didn’t use it when it could have guaranteed a break-even trade or even a higher profit.

Bottom Line: What Is a Trailing Stop Loss?

Trailing stop-loss orders are a powerful risk management tool for intra-day traders. Stop orders are nearly a must but reducing the number of losses you might experience can lead to a much longer career. Trailing stop losses can help.

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Parker Pope
Parker Pope

Parker has spent over 10 years studying the financial markets. He currently manages his own portfolios by trading options and futures, and he’s excited to share his experience with those interested in a hands-on approach to their investments. No fancy tricks or indicators, just a commitment to understanding risk management and knowing the “why.” While he invests actively, he’s built a wealth of knowledge about personal finance and commits his efforts to writing about topics to help people take control of their finances. Parker’s areas of expertise are financial markets and investing.