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Trading has many dilemmas. One that you’re most likely to experience is how to let winning trades run without giving back too much profit when price action reverses – a challenge that’s often solbed with a trailing stop order.
Consider this scenario: you go long on your favorite currency pair and not long after, you are up 80 pips, then 120, then 150. So far, the trade is rolling as planned. However, you can’t decide how much longer to hold on. You step away for some air, and you’re met with shock the next time you look at the setup: the trade is now 20 pips in the negative. The profit you worked hard to build is gone, just like that.
Of course, traders who came before you faced the same problem. That is why they created a mechanism to protect gains while still allowing profitable trades to run as long as possible. This mechanism is known as the trailing stop order on most trading platforms. But what is it? How does it work? This article answers these and many other questions.
What is a Trailing Stop Order?
A trailing stop order is a special type of stop-loss order that tracks price action as it moves in your favor. It does this without your input; that is, once you specify the distance from the highest price since entry (for long positions) or the lowest price (for shorts), it will always maintain that gap to secure gains.
But, hold on a minute. We just referred to the trailing stop order as a special type of stop-loss order. What does that mean?
For starters, a stop-loss order is a command to your broker instructing them to close your position once the market price reaches a specific level. Once triggered, your trade becomes a market order, and the broker can execute it at the next available price.
A stop-loss order is a risk management tool. It limits potential losses if the market becomes unfavorable to your position, or secures gains by protecting profits if price action reverses.
But a regular stop-loss order is static. That is to say that once placed, the stop price doesn’t change. On the contrary, the trailing stop tracks the market price in your favor. The stop level adjusts upwards for long positions, continuing to secure more gains as price action moves the right way. However, if the price falls by a specified amount, the order closes the position automatically. The same happens in short trades: the stop price tracks price action downwards as it falls – it maintains the specified gap. The order is triggered when the market reverses and hits the moving stop price.
Another special type of stop-loss order is the trailing stop-limit order. We have done a deeper dive into this order type in a previous article, which you can read here. A beginner might confuse the trailing stop and trailing stop-limit orders because they sound quite alike. But they are not. We will address the differences in detail later, so read on.
Components of a Trailing Stop Order
When we were explaining the trailing stop order, a keen eye could see that it is built around two elements: the trailing amount and the stop price. Each component has a specific role, and together they determine how your order behaves as the market moves.
Trailing amount
This is the distance the stop level will remain behind the market price as it moves in your favor. Some call it a moving gap because it tracks price action. Most trading platforms allow you to specify this distance in pips, points, or percentages.
For example, if you set a trailing stop at 50 pips, and the market price rises by 50 pips, the stop price automatically adjusts upward by the same amount. The trailing amount doesn’t change – it just shifts higher as the market moves higher for long positions or drops as price action trends downwards for short positions.
The trading platform uses the trailing amount to continuously calculate where to place the stop price. It ensures the stop price always maintains this specific distance from the market’s most favorable point.
- For a long position, the stop price is calculated as: Highest Market Price Since Entry – Trailing Amount.
- For a short position, the stop price is calculated as: Lowest Market Price Since Entry + Trailing Amount.
However, if the market reverses, the trailing mechanism stops moving. The stop price freezes at its most recent level. It waits to be triggered if the reversal continues far enough to close that gap.
Stop price
This is the level at which, once the market price reaches its position, the order is activated. Many call it the trigger level. As we’ve already seen, this price continuously updates as the market moves in the right direction. Also, this price only moves in one direction – up for long trades and down for short trades – to secure gains. It never moves in the opposite direction, even if the market reverses.
How Trailing Stop Orders Work
The interaction between the trailing amount and the stop price is what defines how a trailing stop order behaves. Below is an example that illustrates how this works:
Suppose you buy EURUSD at 1.1621, expecting the buying pressure to keep building. And to protect your position while allowing room for potential upside, you decide to set a trailing stop with a 50-pip trailing amount.
At the moment you place the order, the trading platform automatically sets the stop price 50 pips below the current market price, at 1.1571. Your trade is now protected, which means that if the market suddenly drops by 50 pips, your position will close automatically at the next available price.
But since you’ve chosen a trailing stop, this protective level won’t stay fixed. As long as EURUSD continues to rise, the stop level will adjust upward by the same 50-pip gap.
Now let’s follow the trade step by step:
- When the market climbs to 1.1671, the stop price moves up to 1.1621.
- As price action reaches 1.1721, the stop level trails again, now sitting at 1.1671.
- If EURUSD pushes even higher to 1.1771, the stop price moves once more – to 1.1721.
Notice that at each stage, the 50-pip trailing distance doesn’t change. And you don’t need to lift a finger; the order automatically “follows” the market upward, locking in more profit each time price action makes a new high.
But what happens when price action reverses?
Suppose EURUSD rallies to 1.1801, with the stop now at 1.1751. But this level doesn’t hold for long as the market price plunges by 50 pips. The order activates because now the market price has matched the stop price – the market price hit 1.1751 after the 50-pip dip, which was the stop price after the rally. The position is now a market order, which the broker can execute at the next available price.
At this point, your position closes automatically, locking in a 130-pip profit (from 1.1621 to roughly 1.1751). The trailing mechanism stops functioning once the order is triggered, as the trade is no longer open.
Source: Sigmanomics.com
Trailing Stop vs. Trailing Stop-Limit: How Do They Differ?
We noted earlier that trailing stop orders sound quite similar to another stop-loss order we covered in a previous article, the trailing stop-limit order. The truth is that they behave very differently when triggered. See the table below for details:
|
Trailing Stop |
Trailing Stop-Limit |
|
|
Execution Certainty |
Guaranteed execution. When triggered, it converts to a market order and fills at the next available price, no matter what. |
No execution guarantee. Converts to a limit order that will only fill at your specified limit price or better. If the price moves too fast, the order may never execute. |
|
Price Control |
No control over execution price. You’ll exit the trade, alright, but the exact price depends on market conditions and liquidity at that moment. |
More control over execution price. You set the minimum acceptable price (for sells) or maximum price (for buys), but risk staying in the trade if that price isn’t available. |
|
Best Use Case |
When getting out of the trade matters more than the exact exit price. Ideal for highly liquid markets, day trading, or when you can’t monitor positions. It prioritizes certainty. |
When the exit price matters and you’re willing to risk non-execution for a better fill. Best for less urgent exits in liquid markets where you have time to reassess if unfilled. It prioritizes control. |
