Most of you must be familiar with the concept of stop-loss. A stop-loss is basically a buy or sell order that gets activated automatically whenever the stock or security reaches a certain price. But, the challenge with having such a set stop-loss is that you may not be able to protect your profits or limit your losses. Both these issues can be solved by using trailing stop-loss.
What is a Trailing Stop-Loss?
A trailing stop loss is basically a stop order. However, here the difference is that the stop order is placed at a certain dollar ($) amount or percentage (%) of price away from the current market price of the stock.
- Assume that you have taken a long position. In that case, the trailing stop loss (% or $) would be set as below the current market price (CMP) of the stock.
- Assume that you have taken a short position. In that case, the trailing stop loss (% or $) would be set as above the current market price (CMP) of the stock.
The biggest advantage of a trailing stop loss is that, unlike regular stop-loss, it need not be reset manually every time. It gets automatically reset whenever the price of the stock changes.
The trailing stop loss is available for any stocks, options and futures exchanges that support a regular traditional stop-loss order. Like other stop orders, trailing stops can be set as limit orders or market orders. However, the trailing stop orders are stored in the brokerage’s computerized system, and not at the market book at the exchange like the regular stop orders.
The 2 Functions of Trailing Stop-Loss
There are 2 important functions performed by a trailing stop-loss.
- It helps in maximizing potential profits from the trade.
- It assists in limiting losses and in protecting the profits that have been already made in the trade
#1 Maximizing Profits: When using a trailing stop-loss, the trade would remain open as long as the price of the stock moves in the intended direction. This means that,
- If you have a long position, the trade would be open with an active trailing stop loss as long as the stock is moving higher.
- If you have a short position, the trade would be open with an active trailing stop loss as long as the stock is moving lower.
A trailing stop loss thus helps you capitalize further from future price movements of the stock.
#2 Protecting Profits and Limiting Losses: Assume that the price changes direction by a certain percentage or dollar amount which triggers the trailing stop loss. Then, the trade gets closed, thereby protecting the existing profits as well as limiting future losses.
Remember that you can also change the % or the $ amount of the trailing stop loss whenever you want to, while the trade is still open.
How Does Trailing Stop Loss Work?
This is best explained with an example. Here, the trailing stop loss is done using dollar amount.
- Assume that you buy a stock for $20. Let the CMP of the stock be now $20.05. Let the $ value of the trailing stop loss (TSL) be $0.20.
- This means that the difference between CMP ($20.05) and TSL ($0.20) would give your immediate effective stop loss value of $19.85.
- Now, assume that the CMP increases to $25.97. This means that the effective TSL value would be $25.77 ($25.97 – $0.20).
- Now, assume that the price suddenly drops. These are the various scenarios that would happen.
- Case 1: CMP drops to $25.90. In this case, your TSL still holds good at $25.77 and no stop loss is triggered.
- Case 2: CMP suddenly drops to $25.76. In this case, your TSL gets triggered at $25.77 and your trade will become closed. Your net gain in this scenario would be $5.77 excluding broker commission.