What is a trailing stop loss?
As a spin-off of a stop loss order which automatically exits an investment the moment shares drop below a set price, a trailing stop loss sets a defined percentage or dollar value away from the current market price. It enables investors to benefit from accumulating profits when the market moves in their favour, and to close the order the moment the market works against them.
For a long position, an investor places a trailing stop loss below the current market price. For a short position, a trailing stop loss triggers an exit when the price increases above the current market price. Still confused? Don’t worry - we’ll delve deeper into how it all works here.
KEY TAKEAWAYS
- A trailing stop loss is an instrument used by investors in order to minimize risk and protect profits
- By setting one up, you automatically exit an investment the moment it drops a percentage away from the current price
- The advantage is that it moves in the direction of favourable price movements
- Trailing stop losses are more suitable for short-term investors
- They can be implemented easily through an online trading platform or through a broker
How does a trailing stop loss work?
A trailing stop loss can be added to a trade in the same way as a regular stop price, but a trailing stop loss moves in the direction of favourable price movements to ensure that you’re locking in those accumulating capital. That’s because the trailing stop-loss of, for example, 10% then trails behind the stock as its price moves.
You can set your trailing stop loss to a specific number of points, price, or a percentage distance from the original price. Once the share price peaks and falls to your trailing stop (the distance you’ve decided is acceptable to lose from the current price), the stop loss order will be triggered and your trade will be closed. For example, if an 8% trailing stop loss is added to a long position, a sell trade will be issued if the price drops 8% from its highest price after the purchase has been placed.
The main benefit of a trailing stop loss is that unlike a standard stop loss which executes an exit from the trade the moment it increases or decreases to a certain price, a trailing stop loss allows you to accumulate wealth as the market price moves upwards, whilst escorting you out the trade as soon as the tide moves against you.
Example of a trailing stop loss
Let’s say you purchase stock at £20 per share, you might choose to implement a trailing stop loss of 10%, rather than a stop loss order which sells the stock when it drops to £9.
Using the 10% trailing stop loss example, you would see the stock sold at £9 if the price dropped 10% after its purchase price of £10.
However, since the 10% trailing stop-loss follows the upwards movement of a stock, you benefit from upward movements in a long position. Therefore, if the share price peaks to £20, but then drops by 10%, then you will lock in £18. If it increases to £30 per share, you’d lock in £27, and if it shoots up to £40 per share, you’d lock in £36, and so on – you get the gist!
How to place a trailing stop loss
Trailing stop loss is easy to implement. Most brokers and trading platforms provide a trailing stop loss order option which will work automatically. It’s simply down to you to decide how much leeway you want to give to your investment in percentage or points value.
Most people recommend choosing anywhere between 5% and 20%, but there’s no one-size-fits-all answer. That’s for you to decide based on your own investment strategy and goals. It’s important to note that they’re not set in stone and that you’re able to modify the trailing stop loss order to meet your changing needs.
Advantages of a trailing stop loss
- Automatic transactions: By setting up a trailing stop loss, you don’t need to actively look at your investments. Instead, the investment closes the moment it drops to a certain price.
- Wealth accumulation: Allowing trades to continue with an upwards trend until they reach the trailing stop loss of a specific percentage can result in significant profits.
- Manages emotional investing: By guaranteeing an exit at a certain price or percentage point, stop loss orders remove the burden of emotional investing and you making poor investment decisions!
- Adjustable at any time: The trailing stop loss order can be adjusted at any time, so you can increase and decrease the percentage as you wish.
- Free of charge: Placing a trailing stop loss order is free to implement with your broker or trading platform.
Disadvantages of a trailing stop loss
- Volatility: When trading volatile stocks which move continuously up and down in value, there’s no guarantee that traders will receive an execution price near their stop level if a stock price drops suddenly.
- Can exit you out of a trade too soon: Implementing a trailing stop loss means you can exit a trade during small price movements and can therefore lead you to miss out on the overall upward trend. It’s therefore advised to set the stop loss at a distance at which you don’t expect the investment to drop by.
- Sudden price drops: In instances where you set a trailing stop loss of 5% but it suddenly drops by 20%, your stop loss may not necessarily protect you. That’s because a sudden drop in price doesn’t give the stop a chance to be triggered.