Home » What Is a Trailing Stop Loss in Day Trading?

What Is a Trailing Stop Loss in Day Trading?

What Is a Trailing Stop Loss in Day Trading? - Featured Image

When it comes to doing day trading, it is always crucial to have a strategy for risk management, and knowing when we should initialize an order and when we should complete it is the most important thing to think about for a day trader. Therefore, stop-loss is extremely vital to minimize the loss when the value of an asset does not go in the right direction as we expected. 

There are several types of stop-loss that can be applied in different situations. It is sometimes hard to avoid the loss since there are a lot of different market situations and the market changes unpredictably. Nevertheless, stop loss is actually a pretty helpful tool for those people who are just getting into the trading world.

In order to understand exactly what that is, let’s take a look. 

What is a Stop Loss?

Stop Loss pic

Source: https://tradesanta.com

Before we go into what a trailing stop loss is, let’s first talk about what “stop-loss” is, as they are both really similar to the same concept. A stop loss is a sell order that the investor places just below the purchase price to minimize the potential loss if the price of the asset is not going in the right direction.

Instead of letting the price continue to fall and waiting for it to recover in the future (which may take some time or possibly never happen to go back again), it is better to minimize the loss and withdraw the assets as soon as possible.

Let’s say we are optimistic about Apple’s stock and we believe it is going to rise soon. As a result, we purchase a share of Apple for $130. Despite we believe that the value will increase, we also place a sell order “stop-loss” just below the purchase price of $125.

And this means that if the price unexpectedly falls and reaches $125, our stop loss will be triggered, and we will sell off our assets at market price.

 

Stop loss

Source: https://www.daytrading.se/

Order Types 

What is worth mentioning here is that there are two order types: Limit and Market. A market order is one where you don’t set a specific price, but simply sell it at the market price. Alternatively, limit is the order type that you specify the predetermined price for.

The market order provides the advantage that we can sell assets at the price that the market asks for and then sell them right away. As for the limit order, we decide how much we want to sell the asset for. In other words, we know what we are going to get, but at the same time, it’s not certain that the asset will be sold successfully.  

For the scenario above, we usually want to sell everything as quickly as possible, so the market is usually the best option. Here you can read more about the differences between limit and market orders.

Continuing our example from above, we bought an Apple share for $130, but it did not go as we planned and expected, and the price plunged to $120 before a stop-loss kicked in, resulting in the sale of the share at $125.

While we have made a loss of $5, we can still consider it a positive thing as we exited the business at an early stage and minimized our loss, otherwise, the loss could have been much worse if the price had continued to fall.

What is a Trailing Stop Loss?

Now let’s say that the value of our stock increased instead, the value went from $130 to $140, we are currently at + $10 since our purchase.

From here we still think the value will continue to grow but at the same time, we do not want to take the risk that there is a possibility the price will probably go down to $130 again and we close the deal without any profits. This is where trailing stop loss comes in.

With this, our stop loss is adjusted automatically after the value increases. If the value goes up, our stop loss is adjusted automatically thereafter.

On the other hand, we specify a certain percentage where if the value drops, it automatically triggers our stop loss.

For example, if we have chosen 5% for trailing stop loss, so when the value of our Apple stock rises to $140, our stop loss is adjusted to $133 (140 * 0.95), and if the stock continues to rise to $150, our stop loss is adjusted to $142.5 (150 * 0.95).

Thus, trailing stop loss assures us that we constantly avoid and minimize our losses. There are of course disadvantages with trailing stop loss, and it is really restrictive. If our stock climbs nicely up to $150 but then falls to $142, our stop loss has been triggered, and we have to sell our stock.

We can be in profit for sure. However, if the price continues to rise and reaches new heights, we lose further value. 

How Does Trailing Stop Loss Work?

trailing stop loss
Source: https://www.tradingview.com/

Let’s take a look at the picture above, the green line shows where we went in, and the red line shows where our trailing stop loss hit. As you can see from the graph, we got a nice increase upwards, then it dipped, and then it continued to go up again.

In the second dip, the price dropped so much that our trailing stop loss occurred, and we sold off. After that, the price continued to climb once again and reached new heights.

To sum up, if the price goes up, it will be automatically adjusted as well. 

You can take a look at the video below to find some more information about how to use it.

The Disadvantage 

The main criticism is that it can possibly get you out of the trade too soon when the price just pulls back slightly without actually reversing.

In order to avoid this situation to happen, it is suggested to place a trailing stop at a certain distance from the price at the moment that you actually don’t expect to be reached only if the market changes the direction.

Conclusion

As we all know, there are some risks when you are doing trading and it is really vital to come up with some strategies to manage the risk.

There is no question that trailing stop loss is a powerful tool that should always be in a day trader’s arsenal and everyone can utilize, but it all depends on the risk you are willing to take, and you should be careful to consider and choose where it should be.

To get some additional ideas about the trading strategies, you may want to watch another video and get some more ideas about the trading strategies.

In the end, stop loss is just a tool and the traders get to decide what to use based on the prediction and analysis of the market. 

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