What Is a Trailing Stop and How to Use It?
A trailing stop is a stop order variation that can be set at a specified percentage or dollar amount away from the current market price of a stock. For a long position, investors place a trailing stop loss below the current market price, while for a short position, they place a trailing stop above the current market price.
A trailing stop is intended to protect gains by allowing a position to remain open and continue to generate profits as long as the price is moving in favor of the investor. If the price direction changes by a specified percentage or dollar amount, the order closes the trade.
Typically, a trailing stop is placed at the same time as the initial trade, although it can also be placed after the initial trade.
Why should I utilize trailing stop orders?
Trailing stops can be utilized to limit risk effectively. Traders typically regard them as part of their exit strategy.
Trailing stop sell orders
As the inside bid reaches new highs, the trigger price for trailing stop-sell orders is recalculated based on the new high bid. The first "high" is the inside bid when the trailing stop is initially activated, so a "new" high is the highest point the stock reaches above that initial value. As the price rises above the initial bid, the trigger price becomes the new high minus the trailing amount.
If the price remains unchanged or drops from the first bid or the highest subsequent high, the trailing stop's trigger price remains unchanged. The trailing stop triggers a market order to sell if the dropping bid price hits or crosses below the trigger price.
When should trailing stop orders be used?
Trailing stop orders will only be executed during the regular market session, which runs from 9:30 a.m. to 4:00 p.m. ET. They will not activate or be routed for execution during extended-hours sessions, such as pre-market or after-hours trading, or when the stock market is not opening (e.g., during stock halts, market holidays, or on weekends).
You can choose whether your trailing stop will be effective solely for the current trading session or also for future trading sessions. If they have not been activated, trailing stop orders designated as day orders expire at the end of the current trading session. However, good-'til-canceled (GTC) trailing stop orders will continue over to subsequent regular sessions. Typically, GTC orders are valid for up to 90 calendar days or until they are canceled, whichever occurs first.
Illustration of a Trailing Stop
Suppose you purchased ABC stock at $1,000 per share. By examining prior gains in the stock's price, one might observe that a 5 to 8 percent pullback is common before the price climbs again. These previous movements can be utilized to determine the percentage threshold for a trailing stop.
Selecting 3% or even 5% may be too restrictive. Even slight pullbacks tend to move more than this. Therefore the trade is likely to be terminated by the trailing stop before the price can go higher.
A 20% trailing stop is not appropriate either. Based on current trends, the average pullback is approximately 6%, with larger ones approaching 8%.
A 10% to 12% trailing stop loss would be better. This provides trade room for the deal and also allows the trader to exit swiftly if the price falls by more than 12%. A 10% to 12% decline is greater than a typical pullback, indicating that something more substantial may be occurring; this may be a trend reversal, not just a pullback.
Using a trailing stop of 10%, your broker will execute a sell order if the market falls 10% below your purchase price. This amount is $900. If the price after a purchase never rises above $1,000, your stop loss will remain at $900. If the price reaches $1,010, your stop loss will be increased to $909, 10% below $1,010. If the stock rises to $1,250, your broker will execute a sell order if it drops to $1,125. If the price begins to decline from $1,250 and does not recover, your trailing stop order will remain at $1,125, and if the price falls to $1,125, your broker will place a sell order on your behalf.
What risks are associated with trailing stop orders?
When triggered, trailing stop orders submit a market order, which normally offers execution. Position management is crucial in trading, and it is necessary to understand the dangers associated with trailing stops.
Stock splits. The execution of a trailing stop order depends on third-party market data. Your order could be canceled prematurely due to a stock split, price adjustment, symbol change, and inaccurate or out-of-market value given by one of the third parties.
Gaps. Trailing stops are susceptible to price gaps, which might arise between trading sessions or during trading halts. The execution price may be greater or lower than the trailing amount or trigger price; the trigger price or trailing amount just indicates your desired price at which the market order could be filed.
Market closure. Trailing stops can only be triggered during normal market hours. If the market is closed for whatever reason, trailing stops will not execute until the market reopens.
Fast markets. The price movement could also influence the execution price. When the market swings, especially during periods of high trading volume, the price your order executes may differ from the price you saw at which it was routed for execution.
Liquidity. Parts of your transaction may be priced differently, particularly for orders involving a large number of shares.
No market for the stock. If there is no market for the stock (meaning no bid or ask is accessible) or the stock is not open for trading, your trailing stop market order cannot be executed.
