Trailing stops definition

A trailing stop order is a specific type of stop-loss that automatically follows your position if the market rises, securing your profit, but it will remain in place if the market falls – closing out your position if the market moves against you.

A trailing stop order does not set the stop level at a certain price, but rather at a certain distance away from the current market price. It would be placed below the current market price if you are opening a long position on an asset, and above the current market price if you are opening a short position. A trailing stop is set at a percentage level or certain amount of points away from the market price – this distance is known as the trailing step – and the stop will move to maintain that distance from the current price.

Example of a trailing stop order

Let’s say that you think the DAX is entering into a bull market, so you decide to buy it at 12,555 with a trailing stop set at 12,505. This allows the DAX to move 50 points against you before the stop closes you out.

Since this is a trailing stop, you'll also need to enter a trailing step amount. The trailing step dictates how much the DAX needs to move before your stop moves with it. So, if you have set your stop to move every time the DAX moves five points, then it will move up to 12,510 when the DAX hits 12,560, and so on.

Suppose the DAX 30 hits a high of 12,590 before retracing – your trailing stop would have moved up to 12,540 and would be triggered if the market fell below this price. When your position closed, you would still earn a profit because your trailing stop has broken even.

If you had used a basic stop on the trade, it would have closed your position at 12,505, earning you a loss.

Pros and cons of a trailing stop order

Pros of a trailing stop order

One of the largest benefits of a trailing stop is the flexibility that it offers you, as you don’t have to manually move your stop if your position moves in your favour, and you want to adjust your exposure accordingly.

If you leave a basic stop on an open position, which you don’t then readjust if your trade is profitable, your position will only automatically close if it retraces back to where you originally placed your stop. Any profits that you could have taken from the position, had you closed it earlier, would be lost.

Trailing stops help prevent this from happening, protecting the profits on a successful trade as well as minimising losses.

Cons of a trailing stop order

When you are setting a trailing stop, you have to be careful not to set your trailing step too far away from the market price or too near to it. If you set it too far away, you are at risk of unnecessary losses, but if you set it too close to the market price, you might be closed out before your trade has had the chance to make a profit.