Trailing stop order definition
What is a trailing stop order?
Trailing stop orders allow investors to automatically adjust the price they are willing to sell an asset for in line with changes in their value. Commonly used in the stock market, these tools ensure that profits aren’t lost in the event of sudden volatility.
Normal stop-loss orders are fixed. This means that shares are automatically sold when prices reach below a certain level.
But trailing stop orders work by tracking movements in the market – and if share prices rise or fall, the limit at which a trader will sell rises or falls with it.
Let’s say Derek has bought shares in a fashion retailer for $20, attaching a stop-loss order of $18. If prices rise to $30 before crashing back down to $18, he would have been unable to lock in his profits.
Using a trailing stop order, Derek can choose to only sell his shares when prices fall by a set percentage from their most recent highs. Dollar amounts can also be used. If he had set a trailing stop loss of 10%, his fashion retailer shares would have been sold when they dipped to $27 – subsequently helping him preserve $9 of profit.
The challenge for traders who use trailing stop orders is finding a happy medium between finding a limit that is too strict and too generous. If the limit is set too closely to current prices, it’s possible that normal market fluctuations could unnecessarily trigger a sale. A trailing stop order that’s too far away from current market prices creates the same problem that a fixed stop-loss limit does: it fails to lock in gains.
In order to strike a balance, traders will often turn to technical analysis – data from the past that can help suggest what is going to happen in the future. Derek, the clever man that he is, calculated that shares in his fashion retailer have been known to fluctuate by anywhere between 5% and 7%. By setting his trailing stop loss at 10%, the smartly-dressed trader can ensure that everyday turbulence doesn’t result in him automatically closing his position too early.
Finding the right strategy often depends on the nature of the asset that’s being dealt with. If a company’s stock tends to decent levels of stability, meaning it isn’t susceptible to shock falls and sudden rises, a tighter limit can be an astute decision. Extra leeway is normally only required with stocks prone to erratic movements.