This is not investment advice. The information provided is for educational and informational purposes only and does not constitute a recommendation to buy or sell any financial product.
A trailing stop is a stop loss order that automatically moves with the price. The trader sets a trailing distance, and the stop moves to maintain that distance as the price moves in the trader's favour. The stop does not move when the price moves against the trader. The result is an order that locks in profits as the trade works, while still protecting against a reversal.
The mechanics
The trailing stop is an order ticket in the platform, similar to a regular stop loss order, but with an additional parameter: the trailing distance. The trailing distance can be set in absolute price (for example, $2 below the current price) or in percentage (for example, 5% below the current price). The platform monitors the price in real time, and the stop moves whenever the price moves in the trader's favour by more than the trailing distance.
For a long position, the stop is initially set at the trailing distance below the entry price. As the price rises, the stop rises to maintain the trailing distance. As the price falls, the stop does not move. If the price falls to the stop, the order is triggered and the position is closed at the next available price.
For a short position, the stop is initially set at the trailing distance above the entry price. As the price falls, the stop falls to maintain the trailing distance. As the price rises, the stop does not move. If the price rises to the stop, the order is triggered and the position is closed.
The trailing distance
The trailing distance is the most important parameter. A trailing distance that is too tight will be triggered by normal volatility, and the trader will be stopped out of the position before the trade has a chance to work. A trailing distance that is too wide will give back most of the profits when the price reverses, and the trader will close the position with a small gain or a small loss.
A common rule is to set the trailing distance at 2× to 3× the average daily range of the underlying. A stock with a 1% average daily range has a trailing distance of 2% to 3%, and the stop is unlikely to be triggered by a normal day's move. A stock with a 5% average daily range has a trailing distance of 10% to 15%, and the stop is wider.
A second rule is to set the trailing distance at a level that is meaningful in the price structure of the underlying. A trailing stop just below a recent support level is a structural stop, and the level is more likely to be respected by the market. A trailing stop at a round percentage (like 5% or 10% below the high) is a level that is more likely to be tested by short-term volatility.
Trailing stops versus fixed stops
A fixed stop is set once, at the entry of the trade, and it does not move. The trader who uses a fixed stop knows the maximum loss on the trade at the time of entry, and the loss is bounded. The trader who uses a trailing stop does not know the maximum loss in advance, because the stop moves with the price. The loss can be larger than the initial stop, or the gain can be locked in if the price moves in the trader's favour.
A fixed stop is appropriate for a trader who wants a defined risk on every trade. A trailing stop is appropriate for a trader who wants to ride a trend and lock in profits. The two are not mutually exclusive, and a trader can use a fixed stop on a portion of the position and a trailing stop on the rest.
How to place a trailing stop in the platform
The trailing stop is an order type in the platform, and the placement is similar to a regular stop loss order. The trader selects "trailing stop" from the order type menu, enters the trailing distance, and submits the order. The order is sent to the broker's order book, and the stop is managed by the broker's order management system.
Some platforms place the trailing stop as a server-side order, where the broker's server monitors the price and adjusts the stop. Other platforms place the trailing stop as a client-side order, where the trader's platform monitors the price and adjusts the stop. Server-side orders are more reliable, because the stop is managed even if the trader's platform disconnects. Client-side orders can fail if the platform crashes, and the stop may not be adjusted.
The risk of a trailing stop
The main risk is the gap. A trailing stop is a stop loss order, and the stop does not protect against a gap. If the price gaps through the trailing stop, the order is filled at the next available price, which can be much worse than the trailing distance. The trader who holds a position over a known event is exposed to the gap, and the trailing stop does not protect against it.
A second risk is the platform failure. If the platform crashes or loses connection, the trailing stop may not be adjusted to the latest price. The trader returns to the platform and finds the stop at the old level, and the trader has to cancel the order and place a new one. The risk is small, but the trader should be aware of it.
Related resources
Where to start
If you are setting up a trailing stop for the first time, the most useful exercise is to set the trailing distance on a small position, and to monitor the platform to see how the stop moves. Our broker comparison lists the order types available at each broker, which together tell you whether trailing stops are supported and whether they are server-side or client-side.