Pinpointing the right approach to placing winning trades is challenging. After you’ve designed a potentially profitable trade, you need tools to help you manage your risk. Not only do you need to monitor your risk, but you’ll also want to quickly react to changing prices.
Using trailing stop-loss orders can be effective for risk management by giving you a proactive method to adjust to future price movements. You can use them in the stock market, currency trading or other asset markets to limit losses.
What are Trailing Stop Losses?
You can think of a trailing stop-loss order as a variation of a stop-loss order. A stop-loss order is a limit order where the trader designates a level to close the trade once a stop price is hit. In a trailing stop-loss approach, the stop price is set at a specific level or percentage of the entry price. This level is below your entry price if you are long.
The stop price moves with the security price so that if you have a winning trade, the stop-loss level gets farther away. But if the movement of the price is not favorable, the stop price can stay in place. Day traders often use trailing stop-loss orders to manage fast-moving markets.
This approach can help reduce risk when trading securities like currency pairs. But the strategy has its downsides. If the price isn’t trending in your favor, it can lead you to lock in losses. In addition, determining the stop price can be challenging because of rapid price movements.
Types of Trailing Stop-Loss Methods Used by Forex Traders
Forex markets can move quickly, which makes a trailing stop-loss strategy useful in currency trading. Forex traders can often use multiple types of trailing stop-loss approaches. Some of them include:
Manual Trailing Stop Loss
This approach to trailing stop loss in currency trading is one where traders don't use software to automatically adjust the stop price. Instead, the trader relies on manually judging when and where the stop-loss order should be moved to reduce risk and increase profits.
Say you were involved in currency trading and bought a forex pair using this approach. You might set the stop loss 5% below the price at which you bought the pair. If the price of the forex pair increases or decreases, you may have to manually adjust the stop price to reduce risk. If the price increases to 10% above your entry level, you may want to increase your stop price and adjust it to your entry-level price or lower.
Indicator-Based Trailing Stop Loss
Traders who use an indicator-based trailing stop loss still have to make manual adjustments to the trailing stop-loss order. These adjustments are based on an indicator that measures the average true range (ATR) of the assets. ATR provides an estimate of an asset's movement over a given time period.
Imagine you were trading forex using the indicator-based approach. In such a case you could use the ATR, or similar indicators, of the currency pair to determine its movement. Afterward, you may adjust the stop price to be below the pair’s price to minimize risk.
Price-Based Trailing Stop Loss
Price-based trailing is another commonly used method of placing a stop price. Instead of calculating percentage differences, you determine a fixed price level where you would like to use a stop-loss order.
For example, if you paid 1.1 for USD/EUR, you may set the stop price to 1.0 USD/EUR. If the price rises to 1.11, you may set the stop price to 1.01 USD/EUR. As the price of the pair increases or decreases, the stop price moves alongside it. Using a price-based trailing loss may be simpler to quickly input than a percentage-based trailing stop loss, though the price can also become irrelevant if the market moves significantly.
How Can Trailing Stop-Loss Orders Help Traders Maximize Profits?
A trailing stop loss provides some protection for positions in fast markets because the orders are already placed and can execute when the stop price is triggered. If you want to set levels to maximize your profits, you can set stop levels at levels near recent highs. This may help liquidate the trade at the highest price possible.
You can also adjust the stop price by specifying a percentage difference from current market price, which can help to limit losses and reduce risks. It is a useful tool for getting out of trades according to market conditions.
Combining Trailing Stop Loss with Other Strategies to Increase Profits
Combining trading strategies is an approach that experienced traders may use to trade securities and forex pairs. The trailing stop-loss strategy can be combined with winning strategies with the aim of increasing profits.
If you are a day trader, you would not hold overnight positions, but your trades may be subject to fast market movements during the day. Deploying a trailing stop loss gives you the ability to manage multiple positions without worrying about getting carried out on a trade.
Stay Nimble with Trailing Stop-Loss Orders
A trailing stop-loss order may be used to reduce risk and increase the potential for profits. It allows traders to set a stop price at a specific percentage of an asset price. The stop price then moves along with the price of that asset or currency pair. If you are long, the trade is liquidated when the price drops below the stop price. Whether to use this approach depends on your goals and risk tolerance.
Frequently Asked Questions
Do day traders use trailing stops?
Professional day traders are experts at choosing day trading strategies, and trailing stop-loss orders can be an approach they use to maximize profits.
What is a disadvantage of a trailing stop loss?
One disadvantage of the trailing stop-loss approach is that it might not get triggered if you set the price level too far away. This approach can still lead to losses in a market where prices are going against you.
What is a good percentage for a trailing stop loss?
The percentage level of a trailing stop loss depends on your risk tolerance. Some traders may try to limit losses at 5% to 10% below entry level while others may allow greater losses.
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About Anna Yen
Anna Yen, CFA is an investment writer with over two decades of professional finance and writing experience in roles within JPMorgan and UBS derivatives, asset management, crypto, and Family Money Map. She specializes in writing about investment topics ranging from traditional asset classes and derivatives to alternatives like cryptocurrency and real estate. Her work has been published on sites like Quicken and the crypto exchange Bybit.