A trailing stop is a stop order that is set a certain percentage away from the current market price of an asset. A trailing stop would be set above the current price for a short position and set below the current price for a long position.
In trading, stop loss orders are one of the most important concepts in risk management. As their name suggests, stop loss orders are used to prevent large losses and to preserve your trading capital by automatically closing your open position once the price reaches a pre-specified level.
In this regard, stop loss orders are similar to take profit orders, with the only difference that take profit orders are used to lock in profits once the price hits a pre-specified level in your favour. Stop loss orders are used in the opposite situation – to prevent large losses if the price goes against you.
In general, there are four main types of stop loss orders:
1) Chart stops – Chart stops are stop loss orders which are based on important technical levels on the chart, such as support and resistance levels, channels, trendlines etc. This is usually the best stop loss strategy to use and returns the best results when compared to the other types described below.
2) Time stops – Time stops automatically close an open position after a certain period of time. Time stops are often used by day traders who close their trades by the end of the trading day, or just before the weekend break.
3) Percentage stops – Percentage stop losses close an open position once the loss exceeds a pre-specified percentage of your trading account. However, most risk management rules don’t recommend to set a stop-loss solely as a percentage of the trading account, but rather to use technical levels on the chart to set a stop loss.
4) Trailing stops – Finally, a trailing stop loss is a specific type of stop loss orders which, unlike a hard stop, automatically moves with each new price tick. In the following lines, we’ll explain whether trailing stops are a good idea.
Stop Loss vs Stop Limit Orders
Before we dig deeper into trailing stops, it’s important to draw a distinction between stop loss and pending orders. Beginners to the markets often confuse these two order types as they share certain names which may sound similar to inexperienced traders. While pending orders are beyond the scope of this article, let’s just mention a few in order to distinguish them from stop loss orders.
Pending orders are:
- Stop buy orders
- Stop sell orders
- Buy limits
- Sell limits
- Buy stop limits
- Sell stop limits
These are not stop loss orders!
However, certain trading platforms allow to combine them with trailing capabilities to create a trailing stop limit for example.
How Do Trailing Stops Work?
Trailing stops are a special type of stop loss orders which automatically move the stop loss with each new price tick. Trailing stops are moved only when the price moves in your favour, but stay static if the price starts to move against you.
If you open a buy position on the Euro vs US dollar pair (EUR/USD) at 1.2250 and place a trailing stop 100 pips below the current price, the trailing stop will move (or trail) the price with each new pip to the upside. If the exchange rate rises to 1.2251, the trailing stop will move to 1.2151. If the price reaches 1.2280, the trailing stop will move to 1.2180.
However, if the price moves in the opposite direction after it reaches 1.2280, the trailing stop will stay at its most recent level of 1.2180. As you can see, trailing stops essentially reduce your potential loss when compared to standard stop loss orders as they tighten with each new price tick.
Trailing stops can also be used to lock in profits. Let’s say that the EUR/USD exchange rate from our example rose to 1.2400. Our trailing stop would trail the price and move the stop-loss order to 1.2300, i.e. 100 pips below the current price level. Since we entered the trade at 1.2250, the trailing stop locked in 50 pips of profits if the price starts to reverse.
Finally, if you’re wondering what time intervals are trailing stops – there is no time limit on trailing stops. You can keep them active as long as you want.
How to do Trailing Stops with MetaTrader
Many trading platforms feature trailing stops, and the widely-popular MetaTrader platform is no exception. To place a trailing stop with MetaTrader 4 or 5, simply right-click on the open position, select Trailing Stop from the drop-down menu and select the number of pips to trail the price.
Hint: Many brokers use 5-digit price quotes, with the fifth decimal place called a pipette or point. In the picture above, a trailing stop of 60 points would equal to 6 pips.