The forex offers numerous opportunities for traders to make a profit. The downside is it is marked with a significant risk of loss. Therefore, risk management is vital for any FX trader’s career. One of the ways in which these traders manage risk is by setting stop-loss orders. There are different types of stop losses, one of which is the trailing stop loss.
Trailing stop definition
A stop-loss order is an instruction that you give to your broker to deal you out of a trade if the market goes against you. It is usually set a few pips in the opposite direction from which you predict the market will follow. The goal behind placing this order is to limit your losses in the event your prediction turns out to be wrong. This order remains in effect until you close the trade or you choose to cancel the order altogether.
A trailing stop, on the other hand, works similarly to a stop loss. However, instead of setting it at a fixed value, it works by putting it at a percentage below or above the current price, depending on your trade type. That way, if after making some profits on your open trade, the market changes direction, you can be stopped out without negating all your profits.
How trailing stops work
Essentially, trailing stops work by locking in your profits as your position remains open, up until the currency pair’s price hits your stop. You can either set this trailing stop a specific percentage away from the current price or a number of pips away from it. That way, once prices hit this stop, it closes you out of your position while you still remain in profit.
This trailing stop is superior to the conventional stop-loss when the market moves in your favor but then starts reversing in the opposite direction. The trailing stop will follow the favorable price move but won’t follow the price reversal. That way, once the reversal hits the position of this stop-loss order, you get closed out of the trade without losing any of your investment capital.
When to use a trailing stop
A trailing stop can come in handy when you’re trading a particularly volatile currency pair. However, these high levels of volatility may cause your stop loss to be triggered prematurely. That is why it is important to analyze a specific currency pair’s performance over time. Using indicators such as the average daily range, you can get a measure of how many pips a particular currency pair moves in a day, on average. With this information, you can find the right spot to set your trailing stop.
If you open a buy trade, the trailing stop should be below the current market price. Similarly, if your position is short, you should place your trailing stop above the current market price. Putting the stop too close to the price may close you out of your trade prematurely while setting it too far could lead to bigger losses.
Another thing to remember is that once your stop-loss is hit, your trade is typically closed out at the next available price. This may introduce slippage costs, especially during high volatility. To prevent this, you should utilize a guaranteed stop-loss order, which closes out your trade at the exact price it is set at.
Trailing stop strategy example
Let’s say you open a long trade on GBPUSD, which means you buy the pair in the hope that its price will rise. You set a stop-loss a few pips below your buying price in case the market declines. After a few days, the pair’s price keeps growing steadily, placing you in profit.
At this point, you may decide to manually adjust your stop loss and take it nearer to the current market price or utilize an automatic trailing stop at, say, 2% below the market price. This way, in case a reversal happens at this point, you will be closed out of your trade with the profits you have accumulated thus far still intact, minus the 2% loss, of course. If the price of GBPUSD continues to rise, your locked profits keep increasing until the market reverses and hits your stop.
How to place a trailing stop
We’ve established that a trailing stop is placed a specific distance away from the current price, which it keeps trailing for as long as the market moves in your favor. The most common method is to set the stop to automatically follow the price at a certain percentage above or below it, depending on the type of trade you have opened.
Other traders may set their stop manually following an indicator. For instance, if a currency pair’s price found support at the middle Bollinger Band, the trader may adjust the stop-loss to follow this middle band as the trade develops. Such a trader may choose to adapt their trailing stop in a sequence of stages or as often as every time a new candle forms.
Word of warning
Day traders should be cautious when using trailing stops, especially in choppy market conditions. If such a trader sets the stop too close to the current market price, it may be hit before any profits are realized. If several such trades are closed out by the trailing stop repeatedly, they may culminate in an overall loss.
Conclusion
Trailing stops are a great risk management tool that allows you to lock in your accumulated profits without having to follow your open trades actively. You may set this stop a certain percentage away from the current market price or manually adjust it to follow an indicator that acts as support or resistance. Be careful not to place a stop too tight, as this may close out your position too early or too far from the current price, as you may be leaving too much money on the table.
