How to Set a Trailing Stop
A trailing stop is a flexible stop order that is used by traders and is dynamic. Depending on your trading platform and/or brokerage options, a trailing stop, when automated can be used to protect the unrealized profits already made on your trades. The biggest benefit of using trailing stops is the fact that it doesn’t require the trader to manually watch their trades while at the same time, trailing stops can help your trades or investments against adverse price movements against your trade direction.
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A trailing stop can be used for both long and short positions depending on the markets you are trading (stocks or futures). The trailing stop can be specified in dollar value, tick value; both of these methods are generally used when trading futures or percentage value which is common when trading stocks.
Trailing stops, like all stop orders simply tells the broker when you exit your position and from a trader’s perspective, it will enforce trading discipline as it takes out the emotional factor from your trades, thus protecting both your capital as well as unrealized profits. Trailing stops are GTC (good-till-cancelled) orders.
To best understand a trailing stop and how it is used, let’s take a look at an example trade taken from the tradingsim.com platform.
Assume you bought some shares of Apple (AAPL) at $112.50 and you set your stop loss to $107.30. After your trade was triggered, price initially moved to $119.23 and then dipped to $114.55 and followed up by another leg higher towards $112.57. With price having moved significantly in the favor of your long position, you now shift your stops to a trailing stop, which is moved to the previous low at $114.55.
By doing so, you are effectively locking in a profit of $2.05 on your trade. Soon enough price starts to trend lower and hits the trailing stop level at $114.55, triggering the stop order and exiting your long position with a $2.05 profit.
Now if you had a hard stop that was fixed at $107.30, the trade would have been stopped out for a loss, in effect giving up all of the unrealized gains that were previously made on the trade. As you can see, utilizing a trailing stop offers you a level of safety and can protect any potential profits that the market can give you while at the same time ensuring that the trade has enough room to run its course.
Besides the above example you can also set up the trailing stop in percentage terms. In this case, if a trailing stop of 15% is set, then the long position is closed when price falls 15% from the recent close. The trailing stops based on percentage terms are common for stock investors and is subject to the trading feature offered by your broker.
Example of using trailing stops (MT5 Platform – Futures)
The following screenshot is from the MT5 trading platform for the futures markets. The picture below shows that a trailing stop of 125 points was set for a ES (E-min S&P500 futures) long position.
In dollar value this is $62.50 (25 points = $12.50). The long position was taken at 2279.50. Therefore when price moves 125 points from entry, the trailing stop sets the stop loss to break even.
The next chart below shows this move as the trailing stop is triggered after price moves 125 points in the favor of the trade. This effectively triggers the trailing stop which is now at break even.
Another 25 point move in ES futures, brings the trade to +150 points in the direction of the long position. Thus, the trailing stop now moves the trade from 2279.50 (break even) to 2280.00
The trailing stop remains at 2280, in effect which becomes the new fixed stop loss level.
A trailing stop is ideal when there is a strong volatility in the instrument. A balance needs to be found so that your trailing stop isn’t too tight but at the same time the trailing stop isn’t too wide such that you would lose significant profits that could have been locked.
Three most common indicators that can be used for trailing stops
Although trailing stops can be set at any number, level or percentage you want, there is a method to the madness. If you are not sure what trailing stop levels to use, here are three most commonly used technical indicators that can help you to find an objective level for setting the trailing stops.
Average True Range
As the name suggests, the ATR indicator shows you the average true range of prices for a security. The ATR works across any markets (forex, futures and stocks) and gives you the average expected volatility in the instrument. The ATR has a default setting of 14, but you can use any setting of your choice; 5 or 10. The only point to bear in mind is longer the ATR setting, the less sensitive it is, and smaller the ATR period, the more sensitive it is to price volatility.
The chart above shows a 5-period ATR added to the daily chart for AAPL. Here, the ATR value on the day marked by the arrow was 2.46. What the ATR is telling you here is that price can move $2.46 from the high or the low of the day. Thus, if you were having a long or a short position, you would move the trailing stops based on the ATR value to the levels represented by the dashed horizontal line. This method can be automated in most cases depending on the trading platform. Trailing stop levels can also be set at 2 or 3 times the ATR and is a matter of preference.
The Chandelier exit is an overlay indicator that builds upon price and is one of the best known trailing stop indicator. Chandelier exits are dynamic as they are based off the ATR. The default setting for Chandelier exit is a 22 period, but it is up to the trader on what settings to use.
The Chandelier exit uses a multiple that can be configured. A 22, 2 setting simply means that the Chandelier exit plots the trailing stops based on two times the ATR value subtracted from the low (for long positions) or added to the highs (for short positions).
Parabolic SAR or (Stop and Reverse) is another well known indicator that can be used for trailing stops. The PSAR indicator plots the SAR levels on top or below prices indicating uptrend or a downtrend respectively. The next chart below shows the PSAR levels plotted on the Facebook stock chart.
In the above chart, if you were to take a long position at $93.24 and set the trailing stop to the PSAR levels, the long position at $94.24 would have been closed after price the PSAR at $101.65. Assuming that your order was filled at the right price, the trailing stop would have locked your long position with profits of $8.41. Notice how price started to form a top thereafter before giving up most of the gains.
When should you use a trailing stop?
A trailing stop order is ideal when you are either away from your trading terminal or when you want to capture the trends in the markets without letting go of the profits that the markets already give you.
Furthermore, trailing stop is a function of the trading platform and is broker dependent. Therefore, this feature needs to be check and whether your broker allows the use of setting trailing stops. As mentioned earlier in this article, the way you set your trailing stop also matters and this is again dependent on your broker.
While most trading platforms allow you to set up trailing stops, they are in many cases, tick based, which is not an issue if you were trading futures and can be tolerate even with stocks as well. However, stock investors who prefer to trade for the long term will find that a trailing stop based on a percentage move can be more beneficial both in terms of risk management as well as volatility of the stock in question.
The power of trailing stops can be found during the quarterly earnings releases in the stock markets. Because most of the earnings releases are made either before or after the market hours, the stock price is often susceptible to opening gaps the next day. While a trailing stop will only tell the broker the price at which you want to exit your trade, at the end of the day it all comes down to at what price the order was filled. Still, having a trailing stop is better than having a stop that is further away which will mean that the market will take back most of the unrealized gains.
For the futures markets, a trailing stop is best used during key reports which are common for the commodity, agriculture futures contracts. Again, just like with stops the trailing stops are only a general price level informing your broker when to exit. It comes down to the price at which the order was filled.
Trailing stops - Remember these tips
When it comes to using trailing stops for the first time, traders need to remember a few things.
Understand that most brokers do not place trailing stops for you without your consent. It is your responsibility as a trader to understand what type of an order you want to place. No matter what order you use, ensure that you monitor the trade or the investment at least up until the point that you do not leave any more risk on the table. Once you start locking in some profits, make sure to use the right configuration for setting the trailing stops.
Understand the trailing stop levels correctly. Some brokers and trading platforms allow you to set up trailing stops based on points, while some allow you to set up the trailing stops based on dollar value. Traders need to pay attention to this point when trading futures as the points and the dollar value can vary from one futures asset to another. For example, if you set a 4 point trailing stop in ES futures (E-mini S&P500) that’s about 4 ticks (0.25 x 4) which is around $25.00 and could easily result in the trade being stopped out. Similarly, setting a 4 point trailing stop in GC futures (Gold futures) comes to 4 ticks ($0.10 x 4) or $40.
Understand the broker policy on orders. Most brokers and trading platforms offer a GTC (good-until-canceled) and a GTD (good-for-the-day) orders. While GTC orders are usually kept open for around 30 – 60 days, it is always better to speak to your broker to full understand the expiry limits on the GTC orders. While the futures markets are usually volatile and orders are triggered quickly, with stocks which are usually stuck in a range, it can take months for price to make a significant move which means that your trailing stops need to be active.
Understand that a trailing stop is a not a set and forget. You will still need to monitor your investment. A trailing stop is only as good as the price that the order is filled and in no way will guarantee that your stock or trade will be stopped out exactly at the level trailing stop level specified. A trailing stop is good as a safety net to prevent your investment or trade from losing out more and even to protect your capital, but that doesn’t mean that you can completely ignore your trade or investment after using a trailing stop.
Trailing stops are not always effective and there is no fool-proof way around this. There are times when your trade will hit the trailing stop loss and you can see price reversing direction and continue posting new highs, effectively leaving you on the sidelines. Therefore, care should be taken to apply trailing stops logically. One way to do this is to continuously apply technical analysis to the charts so you can find significant price levels which will be your level of invalidation. In other words, you know that you must exit the trade when price hits a certain level. Using trailing stops also requires a bit of emotional discipline with greed being the biggest psychological factor that a trader must overcome.
In conclusion, using a trailing stop is ideal as it will help you to manage your risks better and also provide a level of safety. By using trailing stops, you are able to lock in part of the unrealized profits while allowing your trade enough breathing space to continue to move in the direction so that you can capture as much profits as the markets can give.
Trailing stops are effective and are known to work in all types of markets.