Why is a trailing stop loss an important strategy to use when trading?
Are trailing stops a good idea?
Nobody can predict with 100% accuracy where a trend will end.
The amount of money that is left on the table by those happy to settle for mediocre gains, is no doubt astonishing.
If you are thinking that a trailing stop will only make your habit of getting ticked out only to see the market reverse worse, than you are doing something wrong.
I am going to list several methods to trail your stop loss and then give you one that I routinely use in my own trading.
What Is A Trailing Stop Loss?
Some people think a trailing stop loss order is confusing but just think: a trailing stop loss means that your order to exit when the market moves against you keeps a certain pace with price.
When price rises, the stop will follow.
If there is a price drop, the stop will also keep pace according to your trailing amount , depending on your method, with the decline in price and hit your sell order to exit the market
An example would be you are long in a Forex pair or a stock and as price moves in your direction, your trailing stop loss price will continue higher as well.
How Does A Trailing Stop Loss Work?
The trailing stop order sits in the market as a limit order waiting to be hit when price reaches it. When the stop is triggered, the stop loss order now acts like a market order which means you could get filled at a worse price than your stop order.
Is Trailing A Stop Loss Good?
When you trail your stop, you are allowing your position to stay in the market while the trend is ongoing. If you use price targets, often times you exit only to see the market continue in your direction.
This issue causes many traders to jump back into the market outside of their trading plan rules.
If you want the chance to ride the big trend to bigger profits, a trailing stop is your best bet.
How To Place A Trailing Stop Loss
How you place your trailing stop loss will be dependent on your trading platform and your trailing stop method.
You can set an automatic trailing stop with Forex brokers such as Oanda which will update your stop loss according to your criteria.
In order to understand how to place a trailing stop, you should know the different between a trailing stop and a static stop loss.
What Is The Difference Between A Trailing Stop And A Stop Loss?
A traditional stop loss is an order that you set when you enter your trade. This is how you limit your risk when taking on a trade in the market.
The stop loss over will sit at the price you have set until either price reaches the stop level, or you take a profit.
Note that as price pulled back and made new highs, the left side had the stop loss remain in place.
On the right, as price increases, the trailing stop made it’s way under the new swing low as price broke upwards.
The benefit to using the trailing stop is:
- You have some risk out of the market so a stop out will be less than your original risk amount (barring price slippage)
- Depending on your initial risk amount, you may have some profit booked if price comes back to your new stop location
The biggest takeaway when considering stops is that with a traditional stop loss, when price moves in your favor, your risk stays the same. A trailing stop decreases risk.
Also consider as an example if you have risked 50 pips and set a profit target of 150 pips in Forex, what do you do if price is at 130 pips?
Do you consider risking the 130 you’ve made plus the 50 in the stop loss, to gain an extra 20 pips?
Smart money says no.
Your Trailing Stop Strategy – Pick Your Method
We have many ways to trail our stop loss from using a certain number of days, a price pattern, technical indicators, to even a percentage based method.
First thing I want to say is – just say no to percentage based trailing stops or a specific dollar amount. These are simple X dollars/cents away from current price or a percentage of the current price.
For example, using a 25% trailing stop would mean if current price is $10.00 and you are long, 25% of 10 is $2.50 so your stop would be set at 10-2.5= $7.50
- How did you come up with the price difference to use?
- Why are you using a certain percentage as opposed to another?
- It does not account for extremes in market behavior
While it may seem easy to use a price based, it is probably not one of the better trailing stop strategies to use.
Use Price Action For A Trailing Stop Loss
Nothing says an uptrend like higher highs and higher lows so why not take advantage of a common trending pattern for our stop loss trailing method?
This trailing stop example is with a chart of the stock for Costco.
It’s been in a decent run to the upside (uptrend) until the end of 2018. I want you to assume you bought into the uptrend around the area of the yellow splash.
- This is our initial stop loss which will remain static until the recent swing high is taken out. We need higher highs to confirm an uptrend. If we move it too soon, we could be taken out by normal price fluctuations
- This is the swing high we need to be taken out. We can see in the middle of the chart that price breaks the line and starts to trend upwards
- We now utilize our trailing stop strategy and bring our stop under the pivot low. Some may use the lows just prior to the low at 3. Personal preference
- Price ranges and a breakout and trend to the upside is still signs of an uptrend. Our new stop is below the lows
- We’ve had a long run to the upside and this move is more of an exhaustion move than a continued trending move. We can aggressively move our stop to the middle of the momentum candle or lower.
This trade would get stopped out but not before making a 29% move to the upside.
When looking for the location below the pivots to place your stop, don’t place them in stop hunting territory. An ATR or looking left and looking for another price location such as opening of a momentum candlestick that is around the pivot makes sense.
Bollinger Bands – Volatility + Moving Average
Another trailing stop method we can use involves a trading indicator like the Bollinger bands.
We could trail along the moving average and some will say you are using dynamic support or resistance. That is not true and using a moving average, while better than random placement, is not something I would consider.
But what about using the moving average as central location and then the standard deviation property of the Bollinger band? This way we give the market room to move and lessen the chance of being taken out before a move really starts.
Assume that you were bearish on the left and after a momentum move and lazy pullback, you entered around the yellow splash.
Your trailing stop strategy here would be to wait until each daily close, and then read the price point of the upper line to define your new stop price (since we are short).
This is 5.5% downside move and you are taken out with momentum.
We turn to longs after the momentum move and after a pullback that is lazy (never want to trade a corrective move that has momentum!), you buy at the yellow splash.
As of this writing, you have locked up a 4% increase in your position.
Average True Range Trailing Stop
Markets go through times of low and high volatility and using an indicator like the ATR, we can take advantage of the increase or decrease in the range of price movement.
- As the average price range decreases, we may want a tighter stop due to adverse moves often times being aggressive
- When the average price change increases, we want to give the market room to run to take advantage of the volatility
- Sudden price shocks in your direction would require a more aggressive approach
The ATR trailing stop will take into account the volatility of the past X amount of days and give you an average price. It takes into account big and small price fluctuations so you are staying in tune with the market.
Here we are using a 20 period ATR setting with a multiplier of 2 for our trailing stop on Japanese currency futures.
In this example, we are considering the 50 day moving average as our trend direction. Even though price breaches the moving average, there is no price acceptance and the average slopes stays down.
We only consider shorts until the right side of the chart where price gaps up and over the average
The red line on the chart is the 20 day average true range of price x 2. At the close of each day, you would adjust your stop location to the ATR price level.
You can see that for the majority of shorts, you do get a good run of price movement before the trailing stop is triggered. Also note that as price forms small ranges, the average true range stop location is closer to price.
When momentum steps in, price pulls away further from the stop location which is good for profit accumulation.
On the right, we consider the green line our stop levels as price heads to the upside where are eventually taken out.
We also are able to cover the point of sudden price shocks.
Adjust For Out Of The Ordinary Price Moves – Aggressive Trailing
Regardless of using price action or a volatility indicator for your trailing stop, moves that are outside the recent price data can skew your stop placement
Often times, as seen the JPY futures chart above, gaps and large price moves can often spell the end of the current leg of price movement or, in some case, change the direction of the short and long term trend.
So what do you do?
Lock in the gift the market has just handed you.
Back to the JPY Futures chart…
A trend channel shows the rhythm of the market and strong price movement outside of the channel, is something to note.
In this example, you could place your trailing stop under the low of the candle that broke the upper resistance line which would lock in more profit than the ATR trailing stop.
Markets that have outsize moves like this often have a sharp snap back in price. While we can never know if price will continue, we also don’t know when price is slam against us.
To err on the side of caution when the probability of a reversal is strong, is sensible trading.
What if was just a strong momentum candle and not a gap?
Use the middle of the momentum candlestick which does give you a tight stop but allows more profit potential than the original ATR stop.
Keep using price action such as the next candle that is printed here.
What can happen is the market will stabilize and you could continue to use the ATR trailer.
Best Trailing Stop Strategy
People are looking for the best way to trail their stop (and enter trades) but the truth is, there is no best.
What is important is that you set a trailing stop if you are looking to make bigger gains in your positions.
I prefer using a volatility based trailing stop along with using price action – adjusting for price moves that are outside the normal.
Using trend lines doesn’t make too much sense because when price pokes below for example, you want to be buying and not selling.
So really, the best trailing stop is one that you understand, will allow you to ride the trend, and one that you will consistently use.