What is a Trailing-Stop?

By mosesbet · Filed Under Spread Betting Comments Off on What is a Trailing-Stop? 

Example of a Trailing Stop at Work

A trailing stop is a special type of stop-loss order which you can set to move automatically (higher or lower) to follow the current market price.  A trailing stop allows you to lock in profits as the market moves upwards.

A number of firms offer trailing stops including IG Index, Capital Spreads, WorldSpreads and City Index.

In order to implement a trailing stop, you need to choose the stop distance (how far away you want the stop-loss from your opening price) and the step size (the number of points in increments before your trailing stop increases).  For example, a trailing stop might be set 20 points below your opening order with a step size of 5 points (i.e. your trailing stop will increase in increments of 5 points).

Example of a Trailing Stop:

Let’s say that you spread bet on SPD gold at $1700-1704 bid/offer price.  You open at $1700 and set a trailing stop 20 points below at 1684.  As the gold price increases then the trailing stop will follow with it.  If the price increases 40 points to 1744 during the day then your trailing stop will follow it and increase 40 points up to 1724 too.

Even if the price dropped all the way to 1660, your trade would’ve exited at 1724, locking in a profit of 20 points above your opening position.

What are the Advantages of Using a Trailing Stop?

The advantages of trailing stops are that they allow you to lock in profits when you’re going long in spread betting. If the market moves in your favour then the trailing stop will move relative to it without having to adjust it manually yourself.  You can then get to the point when you’re guaranteed to make profit no matter what.  Trailing stops are especially good in volatile, high movement markets or even when opening trades at resistance levels since in theory you’d expect the market price to decrease eventually with a need to lock in profits.

The downside to trailing stops are that they are not guaranteed (which means you can still suffer from slippage), they can close you out of trades too early, plus you need to be able to choose the right distance of your trailing stop carefully.  For example, in highly volatile markets it’s recommended that you loosen your trailing stop up to 10-30 points so that the trade doesn’t close out early on potentially profitable trades.  In contrast, you should tighten your your trailing stops to within 5-10 points in low movement markets.

Should you use Trailing Stops?

I’ve heard from a lot of traders that the best strategy for trailing stops is to monitor your trades closely and then implement a trailing stop once you’re in profit.  It’s difficult to use a percentage method (e.g. 5%) for setting trailing stops or even basing it on support/resistance levels since they can break through at any time.

That being said, plenty of day traders, currency traders and traders for quarterly contracts use trailing stops.  I wouldn’t recommend bothering with trailing stops for scalpers.

Another strategy for using trailing stops is when a market looks over overvalued (e.g. a stock price has a much higher P/E compared to its historical P/E).  You would then tighten your trailing stop to lock in a profit whilst taking advantage of any further increases in stock price.

The most important thing to understand about trailing stops is that they are a way for maximising profits and not as a risk-free protection mechanism.  A good time to adjust a stop-loss is when the market hits a higher high and a higher low (i.e. support level).  You can then move the stop to just above the support level which will not only lock in profits but is also less likely to suffer from slippage (since support level by definition means the price is unlikely to drop below this).

 

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