What Is A "Trailing Stop"?
In order to properly define a trailing stop, we must first define a simple stop loss. A stop loss order is an order to buy or sell a given security at a specific price, once the market hits the defined stop loss price. At that point, the original market position is rendered "net zero" or "flat."
A trailing stop is a bit more complex in function, but it is conceptually similar to a regular stop loss order. A trailing stop is a form of stop loss order in which the stop loss order itself moves in concert with the current market price.
There are two basic types of trailing stops: long position stops and short position stops. A long position stop is a sell order that is entered below the current long position in a given market. Upon the current market price hitting the stop loss, this sell order will close out the active long position. A short position stop is exactly the opposite, as it's a buy order placed above the current short market position. The position is then flattened upon market price hitting the stop loss order.
Function Of A "Trailing Stop"
The relationship between the trailing stop order and the current market price can be defined in numerous, different fashions depending on the financial instrument being traded. For example, in the forex market, a trailing stop may be set a certain number of pips away from a specific trade's entry point.
Let's assume that a trade on the EUR/USD pair is entered to the short at 1.2800, with a trailing stop of 30 pips. In the event that price reverses upon entry without going positive and trades at 1.2830, then the trade's result is a net of negative 30 pips. However, if the trade moves 30 pips in favour to 1.2770, the stop loss of the trade now sits at 1.2800, the original entry price of the trade. The position of the trade is still open, and as the price moves in favour by one pip, so does the stop loss. The purpose behind employing a trailing stop is to limit potential liabilities while preserving the opportunity to maximise profit.
Within the present electronic trading climate, the trailing stop has become a popular tool for the modern trader. Current technology provides many options for the crafting of specialised trailing stops. Trailing stops come in many varieties, from the simple static trailing stop we looked at in the above example, to complex and dynamic strategies.
Technical indicators such as moving average crossovers, momentum algorithms, and fractal geometric patterns can all be implemented into a trailing stop trade strategy. The trailing stop can be designed to be as intricate or as complex as the trader desires, but the basic concept of the trailing stop remains the same: limit risk while attempting to maximise capital returns.
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