Trailing Stop Loss

Trailing Stop Loss refers to the percentage that can be fixed by an investor, below which, if the market price of a particular share starts decreasing, the system will automatically execute the sell order. It helps investors prevent themselves from incurring heavy losses and works like a safety measure.

The strategy helps investors protect their profits and acts as a safeguard against downside risk for traders. Investors can use various technical indicators to implement it on their investments. The technique is also observed as a disciplinary measure in capital markets.

• Trailing stop loss is a risk-aversing technique that lets investors set a fixed percentage below the current market price. If the price falls below this threshold, it is automatically sold to avoid huge losses.
• Most investors use online trading platforms, and brokers provide facilities for trading options when it comes to executing sell orders automatically.
• It is observed as a trading discipline comprising both trading and risk management.
• It contributes to a more methodical approach to investing by assisting investors in avoiding making rash decisions during market downturns.

Trailing stop loss is a risk aversion strategy that helps investors reduce risk when the price declines or an unfortunate crash. The technique involves investors setting a predetermined loss percentage, triggering an automatic stock sale if the stock price falls below that. Alternatively, it can be observed as the risk a trader will incur if the price starts falling.

Trailing stop loss options allow investors to manage risk and secure their profits before the market turns unfavorable. This strategy is also known as profit-protecting stops. The most interesting part of the technique is that when the price fluctuates, the stop loss also moves with it in both directions. Many traders use different indicators, such as the average true range (ATR) trailing stop loss, to find the right point to place it.

The placement works like a cap on the loss that a trader is willing to accept. There is no such cap placed on potential gains when market prices rise, allowing traders to enjoy maximum profits without any limitations. Overall, this process helps maintain trading discipline intact and not lose sight of losses that could become massive if not controlled or restricted to a certain extent.

Let us look at some examples to comprehend the concept better:

Example #1

Suppose Frank has just started investing since he is new to the stock market. He decides to take a few risks and always prevents himself from making risky decisions. He studies and finds out about the trailing stop-loss strategy.

Frank bought 90 shares of an automobile company with a market price of $45 per share, making a total investment of $4,050. He believes the company has huge potential, but he fears the market could crash due to the prevailing market conditions and economic conditions. Therefore, Frank decided to apply this strategy on his investment at 4%, a loss of $162, which would bring his investment down to $3,888.

If Frank's investment of $4,050 drops by 4% and reaches $3,888, his shares will automatically be sold. The implementation will only execute if the share price drops by 4%, not before that.

Example #2

Let’s imagine Ford is also an investor in the stock market. He had high hopes for a tech company, ABC. He had invested $5,000 in ABC but decided not to use the trailing stop loss strategy. Unfortunately, the market crashed in the next nine days, and the share price declined by 15%.

As a result, Ford's investment of $5,000 decreased to $4,250, experiencing a significant loss. Ford would have saved himself from heavy losses if he had used the strategy. It is another example of the consequences that can happen if the strategy is not employed, particularly for novice investors adapting to the volatile character of the stock market.

The disadvantages of this strategy are listed below:

• As it works in percentage, the trader remains unaware of the price.
• There is no guarantee an investor will receive the stop-loss order price.
• Many brokers restrict this strategy to ETFs and certain stocks.
• It becomes challenging for traders to employ it in securities with high volatility.

The differences between the three strategies are given below:

This article has been a guide to what is Trailing Stop Loss. Here, we compare it with trailing stop limit, and explain its examples, and disadvantages. You may also find some useful articles here -

• Buy-Stop Order
• Stop-Limit Order
• Good ‘Til Cancelled