Why is a trailing stop loss order an important strategy to use when trading?
Are trailing stops a good idea?
Nobody can predict with 100% accuracy where a trend will end and the amount of money that is left on the table by those happy to settle for mediocre gains, is no doubt astonishing.
I am going to list several methods to trail your stop loss, difference between stop loss and stop limit orders, and how they work.
How Does A Trailing Stop Order Work?
Some people think a trailing stop loss order is confusing but just think: it’s simply an order that trails up (or down) as price evolves.
When price rises, the stop will follow using the technique you have chosen.
If there is a price drop (a long for example), your trailing stop price is the new exit price.
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 To Use?
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 will be dependent on your trading platform and your trailing stop method. Forex traders should know the meaning of pips in Forex and how your broker uses them (2 after the decimal, 4, and 5)
You can set an automatic trailing stop with Forex brokers such as Oanda which will update your stop 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.
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.
Best Stop Loss Strategy
We have many ways to trail our stop 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.
Bollinger Bands – Volatility + Moving Average
Let’s consider using an indicator such as 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 your strategy played consolidations and the tightening of the BBands on the left was a trading setup.
Price breaks out and as price rises, the lower band begins to rise. On the close of each day, you’ll find your new trailing stop price.
You’d note the change in the price of the lower band and adjust your stop accordingly.
There will be times where the “balloon effect” of the bands happen as we see in the middle. We would not lower our stop and it would remain the same until the band rises above it’s previous high point.
The black arrows highlights the sections where your stop would change.
This technique on this daily FX chart led to a 736 pip run.
Some traders will have an issue with the times where price is far above the lower band. Experiment with a lower band setting either by adjusting the look back period or standard deviation setting.
ATR Trailing Stop Loss Strategy
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 using the same chart as the BBand.
Same type of entry and as the ATR moves up with price, you’d adjust your stop at the ATR value at the close of the chart period you are using.
This calculation is from the closing price and you can adjust that to be from highs or the lows. If using highs for long trades to calculate the stop placement, consider a slightly higher ATR multiplier. Otherwise, you may find your stop loss, depending on how large the price range is, inside a candlestick.
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, 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.
Here is a one hour stock chart and for the example, assume you got in at the lows.
A trend channel shows the rhythm of the market and strong price movement outside of the channel, is something to note.
As you trail your stop up in line with the ATR, you draw channels using trend lines. If price breaks the high of the upper channel and stays there, you would change your trailing approach.
Trailing your stop under the lows of each candlestick ensures you will take advantage of the large move in price. In this case, price gapped up and ran over 3%.
Using Percentage For Trailing Stop Loss
There are some traders that use a percentage for a trailing stop loss.
- Use the current high or closing price
- Determine a % you’d be comfortable giving back if in profit
- At trade entry, what is the maximum adverse move you can handle in $$ before you would exit
You will need to determine what the percentage is. Consider using your historical testing to determine the average move against from both a trade entry location and when price is in your favor.
The most common percentage from my study is between 15 and 25%.
Keep in mind that the past does not equal the future. I am not a fan of a percent based stop level preferring to use current market conditions.
Difference Between Trailing Stop Loss And Stop Limit Orders
A trailing stop order will trail below current price at a setting you determine.
For example: You bought XYZ at $50 and will trail your stop $1.00. Current stop is $49.00. The next day, price of XYZ is $53.00 and your stop is $52.00. If the market reverses to $52.00, stop is triggered at the best available price as it is now a market order.
The stop limit order will operate differently.
You buy XYZ at $50 and set a stop loss .75 with a limit of .25.
If the market reverses and hits $49.25, you will only be filled, because of the limit, at a price of $49.00 (50 – .75) or better.
There is a danger in a stop limit order. If a market is dropping with sellers panic, you may not get the order filled and your losses can be large. A trailing stop loss, while converted to a market order, will eventually get you out of the position.
There Is No 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.