What is Trailing Stop?

716 reads · Last updated: December 5, 2024

A trailing stop is a modification of a typical stop order that can be set at a defined percentage or dollar amount away from a security's current market price. For a long position, an investor places a trailing stop loss below the current market price. For a short position, an investor places the trailing stop above the current market price.A trailing stop is designed to protect gains by enabling a trade to remain open and continue to profit as long as the price is moving in the investor’s favor. The order closes the trade if the price changes direction by a specified percentage or dollar amount.A trailing stop is typically placed at the same time the initial trade is placed, although it may also be placed after the trade.

Definition

A trailing stop is a way to modify a typical stop-loss order by setting it a certain percentage or dollar amount away from a stock's current market price. For long positions, investors set the trailing stop order below the current market price. For short positions, they set it above the current market price.

Origin

The concept of trailing stops originated from the need for investors to protect profits amidst market volatility. With the development of electronic trading platforms, trailing stops have become more popular as they can be automated, reducing the need for manual intervention.

Categories and Features

Trailing stops are mainly divided into two types: percentage-based trailing stops and fixed amount trailing stops. Percentage-based trailing stops adjust dynamically with market price changes, while fixed amount trailing stops remain constant. The main advantage of both is their ability to lock in profits when the market is favorable and limit losses when it is not.

Case Studies

Case 1: Suppose an investor buys a stock at $100 and sets a 10% trailing stop. When the stock price rises to $120, the trailing stop automatically adjusts to $108 (10% of $120). If the price falls to $108, the stock will be sold. Case 2: An investor shorts a stock at $50 and sets a $5 trailing stop. When the stock price drops to $40, the trailing stop adjusts to $45. If the price rises back to $45, the short position will be closed.

Common Issues

Investors often misunderstand that trailing stops will protect profits under all market conditions. However, in rapidly fluctuating markets, trailing stops may be triggered, leading to premature exits. Additionally, setting trailing stops too tightly may cause them to be triggered during normal market fluctuations.

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