What is a trailing stop order?
A trailing stop order is an order to sell a stock if its price declines a specified amount or percentage from its previous high. To use this order, you will need to set a specific amount or a percentage below the current market price of the stock. As the price increases, the trailing stop will increase as well in accordance with the percentage or amount you set.
If the price reaches a high and starts declining, the current trailing value will stay the same. Your order will be executed when the price drops from its previous high an amount or a percentage equal to what you set in your order.
This order is used by investors and traders on winning trades to make sure that they keep their positions in stock while protecting gains they already have.
Example of a trailing stop order
Let’s say that you bought a stock at $10 per share. Two months later, the stock moves to $15 per share. You realize that you have made a profit but you don’t want to sell your shares yet.
So, you decided to use a trailing stop order, instead. This order will follow the price movement as it moves up. According to interactiveBrokers, when the stock price rises, the stop price will rise by the trail amount; but if the stock price falls, the stop price will not change and a market order will be submitted when the price reaches the stop price.
For example, let’s say that you chose your trailing amount to be $1 per share. This means if the stock is currently trading at $15 per share, your order will be executed if the stock drops to $14 per share. In addition, if the price increases to $16 per share, the trailing stop will move to $15. If the stock moves to $20 per share, the trailing stop will be at $19. I think you got the idea.
When will the order be executed?
Let’s say that the stock reached a high of $24 per share and reverses the trend. Where do you think the market order to sell your shares will be triggered? If you guessed $23 per share, you are right. Once the price reaches $24 per share, the trailing stop will be at $23.
However, when the price reverses the trend, the trailing price will stay at $23. Your shares will be sold at the best market price possible when the price reaches $23.
The concept will be the same when you a percentage. Instead of setting up an amount, you will set a trailing percentage (4% for example). Once the price retracts that percentage (4%) from its previous high, the order will become a market order and your shares will be sold.
Benefits of a trailing stop order
Like a stop-loss order, a trailing stop keeps your portfolio intact. The difference between a regular stop-loss order and a trailing stop order is the following:
The stop loss will protect you from losing more money whereas the trailing stop will protect you from losing all profits you made on a winning trade if the stock price reverses the trend. In other words, a trailing stop will help you stay in a winning position while protecting gains you already made in the stock.
The trailing stop can also act as a regular stop loss. If the price drops faster and wipes out all your profit, you will still get out of the market if the price continues to decline. This will protect you from losing a lot of money.
Disadvantages of a trailing stop order
Although trailing stops protect your account, they do not guarantee the price you get once your shares are sold. That is once the market order is triggered, you will receive the best possible market price. You don’t get to decide what you get in this case.
If the price plunges, your order could be sold at a very low price or a loss depending on the market condition.
Should I use a trailing stop order?
The market is unpredictable and therefore, you should always use a trailing stop order whenever you are making a profit. If you travel a lot, for example, and don’t have enough time to keep up with the market; it will be a good idea to use a trailing stop.
The order will protect you from losing all gains you made on a winning trade if the price reverses the trend. It can also help you from losing a lot of money if the security you are trading slides instantly.
Final Words
Whether you are an investor or a trader, a trailing stop order can help you increase your gains while protecting your portfolio. That is the order will give a chance to stay in a winning stock and protect gains you already have at the same time.
Due to the high risks of losing the money invested in the market; you should invest only what you can afford to lose.
Happy trading and investing !
