What is a Trailing Stop? - Advantages and Disadvantages
In the world of trading, there are many tools that help us maximize our potential profits and minimize possible losses, that’s why it’s so important to learn how to use them correctly and know them in-depth. In this article, we’re going to discover one of these tools, the Trailing Stop.
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And much more! We begin...
What is a trailing stop?
Have you ever asked yourself, “What is a trading stop loss order?”. If so, you’re in the right place. Like the classic stop loss, the trailing stop is an order whose objective is to close the trade in the event of a market reversal. It’s an essential tool for risk management, like the trailing stop limit. But, what is the difference between a stop loss and a trailing stop?
The trailing stop is a dynamic stop loss! The trailing stop follows the asset price rise in long positions and the fall in short positions, at a predefined distance. It is updated as our position in the market evolves.
How? If the price of the asset advances, the trailing stop loss will automatically follow the direction of the asset. On the contrary, if the price changes trend, the position will be closed, thus ensuring a profit percentage.
➤ The main objective of this order is to protect the profits in our operations: to avoid going to zero if the market turns around.
This tool is very useful when we cannot be aware of our positions, because it works automatically. Of course, it only works with our open platform that has to be active and operational.
If you haven’t downloaded a trading platform yet, you can use the trailing stop in MetaTrader 5, by clicking on this banner:
Here is a video in which we explain, in detail, the difference between a Stop Loss and a Trailing Stop:
How to use the trailing stop loss?
As we have pointed out before, the trailing stop follows the movement of prices in real time and stops when the market changes trend. The operation is basically like this:
- In a long position, the trailing stop will rise in line with the market and will stop when the price falls. The position will be closed automatically when the price falls to the set level.
- In a short position, the trailing stop will follow the downward movement of the price and will freeze when the price rises. The position will be closed automatically when the price reaches the set level.
The trailing stop loss is activated only when it is hit by the price. At that time the operation with benefits will be closed.
Trailing Stop Examples
Let’s look at an example of how to use a trailing stop in Forex to help us understand how this works.
Let's say we open a buy order at 1.11300 and set our trailing stop 30 pips below that price (1.11000).
➨ If the market goes in our favor and the EURUSD rises, for example, to 1.11700, our stop will accompany the price to 1.11400.
➨ If, at that moment, the market turns around and the EURUSD falls, the trailing stop stops and will be activated at that last value, when the price reaches 1.11040. This allows us to secure a profit of 10 pips (the order was opened at 1.11300 and has been closed at 1.11400)
Now let's take an example of a sell order with the same pair. We open the order at 1.11800 and set the trailing stop at 30 pips, in this case at 1.12100.
➨ If the price moves in our favor, the trailing stop will accompany it, always leaving a distance of 30 pips.
➨ If, on the contrary, the EURUSD rises, against our position, it will activate at the last level it reached when the market was in our favor.
If you’re wondering which level is most appropriate to place the trailing stop, it’s best to place it at the last main or local support or resistance of the price. I’ll cover this topic more, later on.
Differences between stop loss and trailing stop
We shouldn’t confuse a stop loss order with a trailing stop order because their function is different.
Although we can affirm that a trailing stop is a type of stop loss order, it should be clear to us that the trailing stop is used to ensure potential profits when the market goes in our favor, while the stop loss serves to limit losses in the event that the market is positioned against us.
The main difference between a stop loss and a trailing stop is that the latter moves along with the price whenever it goes in our favor and freezes when it goes against us.
The stop loss, on the other hand, is always fixed at the level we have established, regardless of the movement of the asset, and will jump when its price reaches that level.
▶ The trailing stop should never be less than the stop loss.
Advantages of the trailing stop
✅ Secure benefits and reduce risk
Like a classic stop loss, the trailing stop allows you to protect your capital by considerably reducing the risk of losses during trading sessions. This is because, at its core, it’s still a stop loss.
Therefore, it acts as a seat belt for your position. In the event of a sudden market reversal, it allows you to close your losses quickly, often faster than if you manually closed your position.
And not only that, but it gives us the possibility of consolidating our profits if the market moves in our favor.
✅ It is dynamic
The trailing stop evolves spontaneously and in real time with your position. Therefore, it’s a good risk management tool during volatility peaks, which helps you take advantage of rapid market movements while protecting your position from a trend reversal in the market.
This is especially useful for scalpers.
✅ Save time
Thanks to the trailing stop, we don’t have to be constantly in front of the screen to manually adjust the stop loss as the market moves, the trailing stop does this automatically.
In addition, it allows traders who have positions in several assets simultaneously to save time since they don’t need to manage each position one by one to manually reverse their stop loss.
When markets experience spikes in volatility or liquidity, time is of the essence and manual management of positions can be time consuming. Therefore, the trailing stop allows you to do in a fraction of a second what would take 10, 20, 30 seconds or more manually.
✅ Suitable for all styles of trading
In addition to protecting scalpers against sudden spikes in volatility, the trailing stop allows them to have a stop loss that will adapt in real time to their position, which can be difficult to do manually.
For intraday traders and swing traders, the trailing stop allows them to study new charts and look for new opportunities, knowing that the risk is under control in their open positions. Therefore, this tool allows you to have more confidence, since it directly affects the psychology of the trader.
While a trailing stop loss is a key tool in helping minimize a trader’s risk while maximizing their profits, like anything, gaining experience with it, first-hand, on the market is invaluable. But what about the risk? You can use a demo account to carry out different strategies, with virtual funds, to gain this valuable experience without risking your funds. That’s right. Zero risk. Click the banner below to get started:
Disadvantages of trailing stop
❌ Permanent connection to trading servers
In order to function correctly and to be constantly updated on the evolution of market prices, the trailing stop requires that the trading platform be connected to the broker's servers.
What does this imply? You must have your computer turned on and the trading platform open at all times or use a VPS (virtual private server) so that your trailing stop works correctly as long as you have open positions.
In fact, the trailing stop is an expert advisor. That is, it works exactly like a standard trading robot that needs a constant connection to the servers to function.
➤ When we turn off the platform, the trailing stop stops moving and remains fixed at the last set point.
❌ Not suitable for highly volatile or range markets
The trailing stop is great for trends or reversals, but it can be tricky in range markets or highly volatile assets. There’s a risk that the position will be closed prematurely with little profit despite the price continuing to move in our favor afterwards.
There are two strategies you can follow:
➣ Increase the distance of the trailing stop loss, to withstand short-term corrections without the order being systematically closed (but this also increases the risk).
➣ Deactivate the trailing stop when you detect that a market is in range or that we’re in a moment of high volatility, and instead use a classic stop loss until the market begins to return to the trend.
How to set a trailing stop order in MT4
Placing a trailing stop in MetaTrader 4 is quite simple, as you’ll see below.
We have three ways to do it:
1️⃣ Mini Terminal of MetaTrader Supreme Edition
This is the fastest and easiest way to place an MT4 trailing stop. When we open the Mini Terminal window we can see several options to fill in. One of them is T/S or trailing stop, the tool we’re going to use in this case.
In order to set the parameters exactly, we’ll press Ctrl on our keyboard and, while holding down Ctrl, we’ll left click.
A new dialog box will appear with three options:
- Fixed risk in EUR.
- % of equity
- % of balance
When we press the 'Set T/S' button, the platform will automatically calculate the trailing stop and we can see it in the Mini Terminal.
2️⃣ Tools included in the platform
In our MetaTrader platform, if we click on the 'New order' tab, a window will appear with several parameters to fill in, although the trailing stop doesn’t appear among them.
In order to access it, you must first open an operation. Then, we have to place the mouse over said operation at the bottom of the platform and right click.
In the window that’s displayed, we go to 'Trailing Stop', and a small menu of possibilities appears. We just have to choose the points we want to fix.
3️⃣ Smart Lines - Mini Terminal
Another very practical way to place the trailing stop in MT4 is through the lines that we draw on the charts. Thanks to these we can not only set a trailing stop loss but also a trailing take profit, which is very useful.
Let's see how.
Suppose we draw an uptrend line on a EURUSD chart. To place the trailing stop loss or the trailing take profit we press the Alt key while clicking the left mouse button.
A dialog window appears. We just have to configure it according to our preferences.
Remember that, for some of these types of trailing stops, you need to have the MetaTrader Supreme Edition platform downloaded. You can get that here (easy instructions):
Trailing stop trading strategies
It’s imperative that traders understand there’s no zero risk in trading, so good risk management is key if we want to be successful in the long term. This is the case in any situation, regardless of whether you want to know how to use a trailing stop in Forex, or any other trading instrument. As when we place a stop loss, when we establish our trailing stop we must be clear about several aspects:
- The maximum loss that we’re willing to accept in each position
- The volatility of the asset we’ve chosen
- Is the trailing stop better suited than the stop loss to my strategy?
- What funds do I have?
Most beginning traders don’t think about these questions. They set both the trailing stop and the stop loss 'by eye'. The important thing when placing them is to take into account the instrument we operate with, the time horizon and if we can be aware of the operation. As I highlighted above, this aspect is vital because the trailing stop works only if we have the active platform.
Where should you set your trailing stop loss (how far)?
At this point in the article, you already know the answer to the question, “what is a trailing stop loss?”. You also know how to use a trailing stop loss. But now comes the key question...How far do I place it?
Together, we’ll now look at 3 different methods:
- Number of pips with ATR
- Number of pips with Fibonacci
- Number of pips with price action
Placing the trailing stop with the ATR indicator
Some traders sometimes use technical indicators to set the trailing stop loss. One of the most used in this case is the Average True Range (ATR), an indicator that reflects the volatility of an asset. In this way, in moments or instruments of greater volatility, the trailing stop would move away from the price, while if the volatility is reduced, the stop would move closer to the price.
➨ If you’re scalping, you can directly use the number of pips indicated by the ATR. Your trailing stop will be quite tight and will allow you to take advantage of brief volatility peaks, but you run the risk that the operation will be closed in the case of too much retracement.
➨ If you’re doing day trades or swing trading, it may be worth applying a multiplier of 2 to the number of pips indicated by the ATR. Why? As you’re looking to capture bigger moves in the market, you should also be able to withstand slightly larger pullbacks.
Multiplying the value of the ATR by 2 is a standard applied by many traders, but feel free to do your own tests to choose the multiplier that suits you best.
Let's see an example of a trailing stop in forex with this indicator:
Source: Admiral Markets MetaTrader Supreme Edition. EURUSD daily chart. Period: November 15, 2019, to July 10, 2020. Prepared on July 10, 2020. Please note that past performance is not a reliable indicator of future results.
If we look at the chart above, the ATR indicator is reflected with a green line in the lower area of the image. The ATR value can be seen on the left side of the indicator box.
In this case, we’ve chosen a period of 14 sessions and the value stands at 0.00747 points, which is equivalent to 74.7 pips, this being the average amplitude range in which this instrument moves during the last 14 sessions.
This data is very useful to establish our stop loss and therefore our trailing stop, since if we establish a stop loss lower than 1 ATR, it’s very possible that it will be reached with a slight movement of the market, thus obtaining many small losses, which will accumulate and harm our results.
Therefore, if we adjust our trailing stop excessively, we can fall into the error of not leaving enough travel for our operation so that it can be carried out in a satisfactory way for our interests. This is why it’s recommended to set the risk level to an amount greater than 1 ATR.
If you want to delve into this and other concepts, you can consult our free webinars and register for the ones that interest you the most. You can find those by clicking on this banner:
Placing the trailing stop loss with Fibonacci
The use of Fibonacci retracements to determine the number of pips of the trailing stop is primarily intended for trend reversal traders.
You must first plot the Fibonacci retracements on your chart. If you don't know how to do this, everything is explained in this article.
Once the pullbacks appear on the chart, wait for your trading signal. As soon as you have an entry signal, you just need to look at the distance between the 0 Fibonacci level and the asset price. It is this distance in pips that you’ll use to place the trailing stop loss!
Another variant of using Fibonacci retracement levels is to use the number of points between the 0 level and the first 23.6 retracement level as the number of pips for the trailing stop.
Placing the trailing stop based on Price Action
A final way to define the distance of the trailing stop in pips is to use price action. This method is especially suitable for traders who open trades based on price movement and who use price action.
To define the number of pips of the trailing stop, you can take the distance between the prices of the last support (if you want to open a buy trade) or the last resistance reached (if you want to go short).
Trailing stop FAQs
Most traders who are new to the trailing stop, have several questions, even after reading a thorough overview of what it is. Below, I’ve compiled some of the most common questions, and their answers:
✦ Can the trailing stop be placed on a tablet?
No, the trailing stop is only available in the MetaTrader 4 and 5 PC applications
✦ Can I place a trailing stop in MetaTrader WebTrader?
No, because MT4 and MT5 WebTrader aren’t compatible with Expert Advisors (and the trailing stop is an Expert Advisor)
✦ Can I place an MT4 trailing stop on mobile?
Not possible, smartphones are not compatible with Expert Advisors, neither Android nor iPhone.
Trailing stop - conclusion
The trailing stop is a tool that, if we learn to use it correctly, can help us improve our risk management.
Using a trailing stop loss, we manage to secure a small percentage of profits if the market goes in our favor and then suddenly turns around.
However, we must be clear before using it that it sometimes leads to premature closing of positions. Likewise, it’s important to know that the platform must be open and operational because, if not, the trailing stop won’t move, it will remain frozen as if it were a fixed stop loss.
If you feel ready to put what you’ve learned here in this article into practice in a risk-free environment, you can do so with a free demo account. If you feel you’re ready to open a live trading account, click the following banner to open one:
Other articles that might interest you:
- How to Use a Stop-Loss and a Take-Profit in Forex Trading
- Support and Resistance Indicators with a Trading Strategy
- The Bid-Ask Spread and How it Can Affect Your Trading
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