Trailing stop

What Is Trailing Stop?

A trailing stop is a dynamic type of stop-loss order designed to protect gains or limit losses on an open position in the market. Unlike a fixed stop-loss, which is set at a static price, a trailing stop automatically adjusts its stop price as the asset's price moves in a favorable direction. This makes it a key component of active risk management within trading strategies. When the market price of an asset increases (for a long position) or decreases (for a short position), the trailing stop moves along with it, maintaining a specified distance. However, if the market price reverses and moves against the position, the trailing stop remains fixed, and if the price hits the set stop level, the order is triggered.

History and Origin

The evolution of sophisticated order types like the trailing stop is closely tied to the advent and widespread adoption of electronic trading systems. While basic stop orders have existed in some form for decades, the dynamic nature of a trailing stop became practical with the rise of computerized trading platforms. Electronic trading first started in the 1970s and developed significantly through the 1990s and 2000s with the proliferation of the internet, gradually replacing traditional floor trading and telephone-based transactions. The ability of computers to continuously monitor price movements and automatically adjust order parameters in real-time facilitated the development and broad availability of such advanced trading tools to investors through their brokerage account.

Key Takeaways

A trailing stop protects profits and limits losses by automatically adjusting its trigger price.
It moves in the direction of a profitable trade but remains fixed if the price reverses.
Trailing stops are customizable, set as a percentage or a fixed dollar amount from the market price.
They provide a disciplined exit strategy without requiring constant market monitoring.
The order is triggered when the market price retreats by the specified trailing amount from its peak (for a long position) or low (for a short position).

Formula and Calculation

The trailing stop price is not a fixed value but rather a dynamically calculated threshold. For a long position, the trailing stop price is determined by subtracting a predefined "trailing amount" (either a fixed dollar value or a percentage) from the highest price the asset has reached since the trailing stop was activated.

For a long position:

\text{Trailing Stop Price} = \text{Highest Price Achieved} - \text{Trailing Amount}

For a short position:

\text{Trailing Stop Price} = \text{Lowest Price Achieved} + \text{Trailing Amount}

The "Trailing Amount" can be defined as:

A fixed dollar amount, e.g., $1.00 below the high.
A percentage of the high, e.g., 5% below the high.

For example, if an investor buys a stock at $100 and sets a trailing stop with a $5 trailing amount, the initial stop price is $95. If the stock then rises to $110, the trailing stop automatically adjusts to $105. If the stock subsequently falls, the stop remains at $105, and if the price hits or falls below $105, the trade is triggered for closure.

Interpreting the Trailing Stop

Interpreting a trailing stop involves understanding its dual function: locking in profit-taking potential while simultaneously protecting against significant drawdowns. The core interpretation lies in the distance (either percentage or absolute dollars) chosen for the trailing amount. A tighter trailing amount means the order will be triggered more quickly on minor price pullbacks, potentially securing smaller gains but also limiting exposure to large reversals. Conversely, a wider trailing amount allows for greater price fluctuations, giving the trade more room to run in a bull market but exposing the portfolio to larger retreats before execution. The choice of trailing amount should align with an investor's capital tolerance and the typical market volatility of the asset being traded.

Hypothetical Example

Consider an investor who buys shares of TechCorp (TCRP) at $50 per share. They believe TCRP has strong growth potential but want to protect their investment. They decide to place a trailing stop order with a 10% trailing percentage.

Initial Purchase: Investor buys TCRP at $50.
Initial Trailing Stop: The trailing stop is set 10% below the purchase price, initially at $45 ($50 * 0.90).
Price Rises: TCRP's price increases to $55. The highest price achieved is now $55. The trailing stop automatically moves up to $49.50 ($55 * 0.90).
Price Continues to Rise: TCRP further climbs to $60. The highest price achieved is now $60. The trailing stop adjusts to $54 ($60 * 0.90).
Price Reverses: TCRP's price begins to fall from its peak of $60. It drops to $58, then $56. The trailing stop remains at $54 because the price has not yet fallen 10% from the highest point ($60).
Trigger Event: TCRP's price drops to $53. This is below the trailing stop price of $54. The trailing stop order is triggered, and the shares are sold at the next available market price, which might be slightly above, at, or slightly below $53, depending on market conditions.

In this scenario, the investor secured a profit, as the shares were sold at a price higher than their initial purchase price of $50, even though they fell from the peak.

Practical Applications

Trailing stops are widely used in various financial markets, including the stock market, forex, and commodities, serving as a versatile tool for investors and traders. They are particularly useful in trending markets, where an asset's price is consistently moving in one direction, allowing investors to capture a significant portion of the trend while protecting against reversals. For instance, an investor might use a trailing stop for a growth stock during a sustained bull market to let profits run. Conversely, a trader with a short position in a bear market might employ a trailing stop to lock in gains as the price falls. These orders are a type of conditional order, where execution depends on the asset reaching a specific price level⁶. Financial Industry Regulatory Authority (FINRA) provides educational resources on how different order types function, including the various stop orders, helping investors understand their practical implications⁵.

Limitations and Criticisms

While a powerful risk management tool, trailing stops are not without limitations. Their effectiveness can be significantly impacted by market volatility. In highly fluctuating markets, minor, temporary price swings can prematurely trigger a trailing stop, causing an investor to exit a position that might have otherwise recovered and continued to be profitable. This phenomenon is often referred to as being "stopped out." The U.S. Securities and Exchange Commission (SEC) highlights that stop orders, once triggered, convert to market orders and are executed at the next available price, which may be significantly different from the stop price, particularly in fast-moving markets⁴.

Furthermore, some critics argue that the widespread use of automated stop orders, including trailing stops, can exacerbate sharp market declines, as a cascade of triggered orders can lead to rapid price drops. For example, during the "Flash Crash" of May 2010, automated trading algorithms, which included various types of stop orders, were implicated in contributing to the market's dramatic, albeit temporary, plunge³. Academic research also suggests that stop-loss orders can increase volatility and create the potential for "stop-loss cascades" that result in large price movements¹, ².

Trailing Stop vs. Stop-Loss Order

The trailing stop is a specialized variation of a standard stop-loss order. A traditional stop-loss order is set at a fixed price point below (for a long position) or above (for a short position) the entry price to limit potential losses. Once this fixed price, known as the "stop price," is reached or breached, the stop-loss order becomes a market order and is executed at the prevailing market price. This stop price remains static unless manually adjusted by the investor.

In contrast, a trailing stop is dynamic. While it also aims to limit losses and protect gains, its stop price automatically "trails" the market price as long as the market moves in a favorable direction. If the asset's price increases, the trailing stop price moves up with it, maintaining a fixed distance (e.g., a percentage or dollar amount) from the new peak. If the price reverses, the trailing stop price remains stationary. The order is only triggered if the price falls back by the specified trailing amount from its highest point. The key difference lies in this automatic adjustment, offering greater flexibility and automated profit-taking potential without constant manual intervention.

FAQs

How do I set a trailing stop?

You typically set a trailing stop through your brokerage account's trading platform. You specify the asset, the number of shares, and the trailing amount, which can be a fixed dollar value (e.g., $1.00) or a percentage (e.g., 5%). The platform then automatically calculates and adjusts the stop price.

Can a trailing stop guarantee my execution price?

No, a trailing stop, like a standard stop-loss order, typically converts to a market order once triggered. This means it will be executed at the next available market price, which might be higher or lower than your specified stop price, especially in fast-moving or illiquid markets. There is no guarantee of execution at the exact stop price.

Is a trailing stop suitable for all market conditions?

Trailing stops are generally more effective in trending markets where prices are moving consistently in one direction. In highly volatile or choppy markets, frequent minor price fluctuations could prematurely trigger the trailing stop, leading to multiple small losses or missed opportunities if the price later recovers. Adjusting the trailing amount based on market volatility can help.

What is the advantage of using a percentage-based trailing stop?

A percentage-based trailing stop automatically scales with the price of the asset. As the price increases, the dollar value of the trailing amount also increases, maintaining a consistent risk management profile relative to the asset's value. This can be beneficial for high-priced or rapidly appreciating assets.

Can I modify a trailing stop after it's placed?

Yes, most brokerage account platforms allow you to modify or cancel a trailing stop order at any time before it is triggered and executed. This flexibility enables investors to adjust their investment strategy in response to changing market conditions or their own outlook.