Understanding Trailing Stops and using them correctly

A wisdom of the stock market that is heard time and again is: “Limit losses and let profits run”. The trailing stop is a simple tool that allows you to do just that. It limits losses and maximizes your profits. And it does so completely automatically after activation, without you having to sit in front of your computer and watch the prices.

What exactly is a Trailing Stop Order?

A Trailing Stop is basically a smarter version of a Stop Loss Order. The small but important difference to the normal Stop Order is that the Trailing Stop follows the price behaviour automatically. This means that the price at which your position is to be stopped is automatically adjusted if your position continues to move in the direction you are trading. In this way, profits already generated are secured and the chances of winning are not limited upwards as with a take-profit order.

If the price changes direction and runs against you again, you will be automatically stopped at the trailing stop level, just like a normal stop order. The distance to which the order should “follow” the current price is individually adjustable. Once set, the trailing stop works automatically, so that you do not have to sit at your computer all the time for the order to be executed.

For example, if you buy a share at 80 Euros and set a Trailing Stop at a distance of 5 Euros, the Stop will always follow the price at a distance of 5 Euros if it continues to rise. Let’s assume that the stock rises to 110 Euros over time without ever losing 5 Euros or more on the way. Then its stop was automatically adjusted to 105 euros. If the share then falls from 110 to 105 euros again, you are automatically stopped at 105 euros and have secured a profit of 25 euros per share.

Most Forex brokers offer their customers trailing stop orders free of charge in their trading platform. However, some brokers require a certain minimum distance from the current price when setting a trailing stop. The trailing stop can not only be used for Forex trading, but also for trading all kinds of other financial products such as CFDs, certificates or futures.

Summary:

  • Trailing Stops follow the price based on the specifications
  • Trailing Stops can be used with almost all financial products
  • some brokers require minimum distances from the current price

Select distances at trailing stop

The distance of the trailing stop should correspond to the risk that the trader is willing to take. If you have already realized some profits and do not want to give away much of them again, you should choose a rather small stop distance. If you want to hold positions in the long term and survive possible setbacks, you should of course set the stop distance and thus the buffer before you are stopped out somewhat more generously.

Example of a Trailing Stop Order

In this example we see the 30 minute chart of the DAX30, which was in a downward trend there. If you had opened a short position when you entered the market, it would have gone relatively comfortably into profit a short time later. At this point one could have used a trailing stop. Depending on the distance of the trailing stop from the current price, different price marks and thus smaller or larger profits would have been possible.

With a relatively narrow stop distance, you would probably have been stopped after the small reset at low 1. If the distance had been a bit larger, low 2 or even low 3 would have been possible. If the distance between the trailing stops had been really wide, even low 6 would have been possible. But here, of course, one would have taken the risk of losing the now not inconsiderable gains if the price were to move in the opposite direction again.

In this situation, a partial sale (scale out) would have been a good idea. For example, half of the position could have been sold at low 1 and the other half could have been left in the market with a trailing stop. The distance could have been chosen in such a way that you would have been stopped out just below the entry point if the trend had broken and the price would have developed against the trader again. In this way you could have already secured a part of the profits and still have a position with good profit prospects but without risk in the market.

Conclusion

The Trailing Stop Order is an excellent tool to maximize profits when trading currencies or other financial instruments while limiting risk. Depending on how the distances to the current price are chosen, there are various trading strategies where the Trailing-Stop can be used. Of course, the distance at which the order should follow the stop at the current price is crucial for success.

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