Trailing Stop Loss Benefits: How To Lock in Profits and Limit Losses

Last Updated on June 1, 2021

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Maximizing profits in the stock market can be challenging. But avoiding losses can be even harder. A trailing stop loss can be your key to minimizing loss and ending your day with impressive gains.

What’s That?

A trailing stop loss is a kind of day trading stop order that is able to minimize risk and protect profits. It’s a strategy that, when employed correctly, can bring you out of a trade before the price drops too low. The trailing stop loss can prevent excessive loss in a day trade, employing a pre-determined exit strategy if the market price drops below the designated amount.

Essentially, the trailing stop loss locks in profits by “trailing” the market price as it rises, but limiting loss if it happens to go back down. For day traders, this method will help you control losses instead of letting the volatile market eat up your returns.

Why Use Trailing Stop Loss?

You enjoy keeping your money secure? If you’re investing in the market, things are bound to go up and down. Sometimes, the market goes down lower than you bought in, and your money goes down the drain with it. Trailing stop loss prevents that inevitable loss before it gets out of hand.

How It Works

After a trailing stop loss is set, it works similarly to a stop-loss order. The difference is that the trailing stop loss will climb with the market price as it increases, but stop as it drops low. For example, if you’ve bought a stock at $100, you can set a trailing stop loss by percentage or amount.

Let’s say you set it at $1.

If you’ve entered the trade at $100 per share, the trailing stop loss would be set at $99. If the price falls below $99, you’ll be taken out of the trade, and your investment will be (mostly) protected. However, as the market increases and the stock goes from $100 to $105, the stop loss works its way up to $104, “trailing” behind the value. If the market starts heading back down, the trailing stop loss will have you exit the trade by submitting a market order before your profits are completely diminished.

Does It Work With a Short Trade?

Yes! Except the difference is that the trailing stop loss works its way down as the price lowers since your goal is to buy back the borrowed stock at a cheaper price. As the value drops (which is good when shorting the stock), the trailing stop loss follows, until the value starts to rise again, in which case the exit commences and the market order is automatically submitted.

Here’s the Problem

The market is volatile. The trailing stop loss doesn’t automatically account for the market’s imminent increase and decrease, automatically exiting trades before a stock can go back up. By going the safe route, the trailing stop loss can exit the trade too soon, despite the chance of the stock heading back up and even higher than it was before.

Let’s say your $100 stock went to $110 a share. The trailing stop loss would work its way to $109 (if you set it at $1). If the share price falls to $109, the order is submitted and you’re taken out of the trade. However, that stock could have gone back up to $110. In fact, it shot up to $120 in the next hour! Those would have been profits if the trailing stop loss didn’t take you out of the trade too early.

Another issue is that the safety net isn’t as sturdy as you may think. If the share price drops $10, the trailing stop loss won’t be able to catch it in time, and you’ll be out the $9 per share. The stop-loss won’t trigger quickly enough to prevent all that loss.

What About a Trailing Stop Limit?

A trailing stop limit works by preventing a sale below the stop limit. For example, if you’re set to set $1 below market price but the price drops $2 below, the trailing stop limit will prevent a sale until the price comes back to the appropriate price. This can help prevent massive losses from automatic exit trades.

I’m In. Now What?

Trailing stop loss orders can be placed with most brokers. Make sure to do your research on the market and the particular stock, and place an appropriate stop-loss. The stop-loss will now trail the share price and prevent major losses if it comes down.

Remember: You can always trail your stop loss manually. You’ll just need to pay closer attention to your trades. 

Key Advice: Resist the urge to reset your trailing stop loss. Though it might seem like things are going great, it may end lower than expected and your earnings can disappear. Trust your stop-loss and don’t make any rash decisions in the name of money. However, that doesn’t mean you shouldn’t take in the good when it comes. If momentous rises are bringing in massive gains, reining in your trialing stop loss can account for momentary fear from other traders. As they pull back slightly and the stock comes down a bit, your trailing stop loss may exit the trade too soon. There’s a chance the rise will continue after the short-term sell-off.