What Is a Trailing Stop Loss & How Does It Work?

In the world of stock trading and investing, managing risk is paramount. One tool that can assist traders and investors in protecting their gains and limiting potential losses is the trailing stop loss. This approach helps traders protect their gains while allowing them to benefit from further price increases. However, it does not guarantee profits.

Let’s understand what a trailing stop loss is, how it works, and the advantages of using it.

What Is a Trailing Stop Loss?

A trailing stop loss is a type of stop order that moves with the market price of an asset. Unlike a traditional stop loss, a trailing stop loss for a long position moves up when the market price rises. It helps traders protect their gains while allowing them to benefit from further price increases.

As the market price of an asset rises, the trailing stop loss also moves up and maintains the set gap. However, if the market price falls, the stop loss stays at its last adjusted level.

The primary purpose of a trailing stop loss is to protect profits and limit potential losses. It helps investors protect their gains as the asset's price increases. It also triggers a sell order when the price falls to the set stop-loss level.

How Does a Trailing Stop Loss Work?

Let’s understand how trailing stop loss works using an example.

Example: Suppose you purchase 100 shares of XYZ Corporation at ₹50 per share. You decide to set a trailing stop loss order at 10% below the current market price. Therefore, your trailing stop-loss would initially be set at ₹45 per share, which is ₹50 - 10% of ₹50.

Now, as the market price of XYZ Corporation's shares starts to rise, your trailing stop-loss adjusts accordingly. If the price increases to ₹60 per share, your trailing stop loss will also move up to ₹54 per share, which is 10% below ₹60. This means that even if the stock price subsequently drops, your trailing stop loss will remain at ₹54 per share. If the price reaches ₹70 per share, your trailing stop loss moves to ₹63 per share.

However, if the market price reverses and falls, the trailing stop loss will be triggered only when the price hits or goes below the most recent trailing stop loss level.

In our example, if the price falls from ₹70 to ₹63, the trailing stop loss is triggered because it has reached the set stop loss level. A sell order is then placed. However, the shares may be sold at a price different from ₹63, depending on market conditions. If a stop-limit order is used, it may remain unexecuted if no buyers are available at the limit price or higher.

Advantages Of Using Trailing Stop Loss

The following are the benefits of using a trailing stop loss.

Helps Protect Profits

As the asset price rises, the trailing stop loss also moves up to maintain the set percentage or amount below the highest price reached since activation. This helps protect some of the gains without needing to adjust the stop loss manually.

Allows More Room for Price Growth

A trailing stop loss allows traders to benefit from further price increases instead of selling at a fixed profit target. It helps traders stay in a trade as long as the price continues to move in their favour.

Reduces Emotional Decisions

Traders may make poor decisions due to fear or greed. A trailing stop loss follows a set rule and helps reduce emotional decisions when exiting a position.

Helps Limit Losses

If the market price starts to fall, the trailing stop loss stays at its last set level. If the price reaches that level, a sell order is triggered. This can help protect gains or limit losses, but it does not guarantee a particular selling price.

Saves Time and Effort

Traders do not need to watch the market all the time. Once a trailing stop loss is set, the broker's trading platform can track the price and trigger a sell order when the stop level is reached, subject to the platform's rules.

Flexibility

Traders can choose a trailing percentage or fixed amount based where supported by their broker, based on their needs and the asset's price movements. A wider trailing distance gives the price more room to move, while a smaller distance may trigger a sale sooner.

FAQs

What is a trailing stop loss?

A trailing stop loss for a long position is a type of stop order that moves up when the asset price rises, helping traders protect their gains and limit potential losses.

How does a trailing stop loss work?

A trailing stop loss follows the asset's price as it rises and if the price falls to the set stop level, a sell order is triggered.

Does a trailing stop loss guarantee profits?

No, a trailing stop loss does not guarantee profits since the actual selling price may be lower than the stop price due to market conditions.