What is trailing stop loss? Here’s how it helps to minimise losses

A successful stock market trader should always excel in risk management. One of the tools that can come handy for this purpose is trailing stop loss.

Trailing stop loss is essentially a more advanced form of stop loss that helps investors in maximising gains while limiting potential losses.

In traditional stop loss orders, an investor enters into an automatic order to exit a trading position that he/she holds if the price of the asset hits a pre-determined level. This is done to limit losses and reduce risk exposure in case the market movement turns unfavourable.

However, in trailing stop loss orders, the stop-loss level keeps moving with the market price of the asset in case of favourable price movement, securing profits. In case of unfavourable movement, the stop loss that was set earlier stays in place, closing out your position if the market moves against you.

Trailing stop loss sets ‘distance’, not ‘price’

The key highlight of a trailing stop loss order is that it sets the stop-loss level in terms of distance from the current market price, rather than fixing an absolute price level as stop loss.

In other words, a trailing stop loss is set as a percentage, or certain number of points away from the prevailing market price.

If you are opening a long position on an asset, a trailing stop loss would be placed below the current market price. On the other hand, if you are opening a short position, it would be placed above the current market price.

Let’s understand this with an example.

Suppose you purchased 100 shares of a stock at a price of ₹50 per unit. Since you want to protect your trade against losses in case the stock price starts falling, you set a trailing stop loss order at 10% below the current market price of the shares. In this case, your initial trailing stop loss would be at ₹45 per share (as 10% of ₹50 is ₹5). Now, if the stock price starts rising, your trailing stop loss level would also get adjusted accordingly and not remain at the same ₹45 levels.

Suppose if the price of the shares you own increases to ₹60 per unit, your trailing stop loss will move up to ₹54 apiece (10% below ₹60).

How trailing stop loss helps to minimise losses

In case the value of the stock owned by you starts dropping suddenly, reversing the initial gains, your most recent trailing stop loss would get triggered and your shares would be automatically sold at the prevailing market price. In this example, if the stock price dropped from ₹60 to ₹53, the trailing stop loss would get triggered, and your trade would be closed. You would still earn a profit as your buying price was ₹50 per unit. But, if you had used a basic stop loss on the trade, you would have closed your position only at ₹45 (the initial stop loss), earning you a loss on your trade.

Important factors to consider while using trailing stop loss

The most important thing to remember when you are setting a trailing stop loss is to assess your risk tolerance and set an appropriate trailing percentage or amount. If you set a trailing stop loss that is too far away from the market price, you are at a risk of losing potential gains (in case of favourable market movement) or attracting more losses (in case of a downward spiral). However, if you set it too close to the market price, your trade might get closed prematurely before you get the chance to make a profit.

In conclusion

It is advisable for investors to use trailing stop loss only after considering factors like risk tolerance, investment goal, investment horizon and market conditions to make the best use of this risk-management tool.