A trailing stop is a type of order used in trading forex to adjust the stop loss level as the market moves in a profitable direction. For instance, if you have a long (buy) position, your stop level increases as the market rises. Conversely, when taking a short (sell) position as the market falls, you reduce the level of your stop.
The trailing stop works by setting a stop loss level at a certain distance or percentage from the current market price. If the price moves in the investor's favor, the trailing stop will adjust the stop loss level accordingly to protect the profits.
For example, if a trader buys the USDJPY at 130.05 and sets a stop of 129.95, if the stock price rises to 130.65, the trailing stop will adjust to 130.55, which is ten pips below the current price. If the USDJPY falls back to 130.55, the trailing stop will sell the position at the market price, thereby protecting the investor's profit of 50 pips.
Trailing stops can be helpful for traders who want to limit their losses while allowing profits to run. The trailing stop will enable traders to lock in profits while minimizing the risk of large losses if the market turns against them.
To use a trailing stop, traders can use an automatic tool or do it themselves. Within MT4, there is the ability to use a trailing stop which automatically adjusts your stop loss. Traders who want more control can adjust the stop loss, which can be time-consuming.
Here are some ways in which a trailing stop can improve your trading:
Locking in profits
When you set a trailing stop, you can ensure that you protect your profits as the market moves in your favor. There is nothing more frustrating than losing a large amount of your profit. Using a trailing stop to lock in your profits will reduce stress levels and make it much easier to make consistent profits trading forex.
Trailing stops also help you to limit your potential losses. If the price starts to move against you, the trailing stop will activate once it hits the set percentage or dollar amount and close the trade at a specified loss level. A trailing stop can prevent a profitable trade from turning into a losing trade and increase your win percentage.
Reducing emotional trading
An automatic trailing stop can help traders minimize emotional trading by eliminating the need to monitor the market and manually adjust stop-loss levels. This can help prevent traders from making impulsive decisions and sticking to a trading plan.
A trailing stop helps traders maximize their profits. In a strong trend, it isn't easy to forecast a price level where to take profits. Some traders do not set a target and use a trailing stop to exit their position. The trailing stop allows them to ride the trend for as long as it lasts while at the same time protecting their profits and minimizing their losses. Riding a strong trend on a few trades and have significantly improve your long-term trading performance.
Improving risk management
Traders can better manage their risk by using a trailing stop. It ensures that trades are closed at a predetermined loss level, reducing the likelihood of significant drawdowns in their trading accounts.
Tips for using trailing stops
Use support and resistance
Using support and resistance with a trailing stop can improve your results. For instance, when using a trailing stop in an uptrend keeping the stop loss below the moving average or trend line support is a good idea. Likewise, when using a trailing stop in a range market, keeping the stop below the previous bar low when holding a long position can improve performance.
Use a time stop
A time stop is where you reduce the size of your stop loss over time rather than price movements. Most successful trades are profitable relatively quickly. However, holding a position for a long time can be stressful and prevent you from trading other opportunities. For example, every 1 hour, you would reduce your stop loss by five pips.
Do not use it too quickly
Using a trailing stop too quickly can result in missed profits. Initially, when many traders use a trailing stop, they think it can solve all their problems and use it too quickly. For instance, when day trading, as soon as the trades goes 1 or 2 pips in the money, they reduce their stop. Unfortunately, perfecting trade timing is rare, and you must be patient for the market to move significantly in your preferred direction before using a trailing stop.
A trailing stop can be a valuable tool for traders to manage their positions and risk while taking advantage of market movements. It allows traders to ride the trend while limiting their losses if the market turns against them.