Limiting the losses incurred by investors while trading is very challenging. However, online brokers, with the help of technology, are always on the lookout for doing just that. There is a kind of order in day trading called a ‘trailing stop loss,’ which allows you to dynamically adjust your stop loss based on the direction of price movement.
If the price of the security moves in your favorable direction, the stop price moves with it. However, if the price of the security is no longer favorable for you, the stop price, in that case, stays in place.
This article will explain to you all about trailing stop loss, how to use them, and which trailing stop loss is the best.
What is a Trailing Stop Loss in Stock Trading?
When you are a part of the stock market, it is quite natural that you will suffer losses at some point in time. However, if you are very keen on protecting yourself from day trading losses while locking in your profits, a trailing stop loss (TSL) is the perfect order for you.
A trailing stop-loss order makes sure that your unrealized profit doesn’t get wiped away due to wild price swings.
Here’s an example of how trailing stop loss is always better than traditional stop loss:
Let’s say you buy a stock for $100, and put a traditional stop loss at $95. The price moves up from $100 to $110 but you don’t book profit assuming that it would move up even further.
However, after touching $110, the price of the stock starts to decline rapidly and touches $95 in the next few minutes. What just happened? Well, you ended up in a net $5 loss when you could make a $10 profit.
Now, in the same scenario trailing stop loss would have helped to limit your loss. The trailing stop loss could be configured to move based on the direction of price movement.
So you could have set it in a way that when your net unrealized profit reaches 2% ($102 in this case), the stop loss would move $1 upwards for every $1 rise in the stock price from there onwards.
Below is the entire calculation to make this clear:
Stock Price = $100, Stop Loss = $95, TSL = $95
Stock Price = $102, Stop Loss = $95, TSL = $95
Stock Price = $103, Stop Loss = $95, TSL = $96
Stock Price = $110, Stop Loss = $95, TSL = $103
Stock Price = $105, Stop Loss = $95, TSL = $103
Stock Price = $104, Stop Loss = $95, TSL = $103
Stock Price = $103, Stop Loss = $95, TSL = $103 (hit)
Stock Price = $96, , Stop Loss = $95, TSL = $103 (already hit)
Stock Price = $95, , Stop Loss = $95 (hit), TSL = $103 (already hit)
If you observe the above example carefully, a trailing stop loss could have given you $3 net gain, whereas the traditional stop loss could have caused a loss of 5%.
Types of Stock Trade Orders
Broadly, there are five types of orders that you can place with your broker. Let’s take a look at them:
- Market Order: Through this order type, you can sell or purchase a stock at the current market price. However, you cannot control the amount paid for the purchase or sale of the stock. The market strictly sets this price.
- Limit Order: This order is used to sell or purchase a stock at a particular price or a better one. This order essentially prevents you from selling or purchasing stocks at an unwanted price. Therefore, if the market price is not the same as the limit order price, the order will not be executed.
- Stop Loss Order: A stop-loss order closes your position only when it has reached a certain price. This order is engineered to protect and limit your loss.
- Stop Limit Order: This order is conditional and combines the features of a limit and stop order. To place this order, you have to identify two prices – the limit price and the stop price. As soon as your stock hits the stop price, the order turns into a limit order.
- Trailing stop order: This order is similar to a stop order, but it dynamically adjusts the stop price based on price movements.
How is Trailing Stop Loss Beneficial?
Now, let’s look at how trailing stop-loss order is beneficial:
- A trailing stop-loss order does not put a cap or ceiling on your profits.
- A trailing stop-loss order comes with elasticity as you are allowed to customize your risk management plan.
- The trailing stop loss is a profit-protecting stop.
- You can choose any percentage as a trailing stop loss percentage.
- This type of order prevents you from making reckless decisions and sheds light on predetermined objectives.
- It can be used for both long and short positions
- Stockbrokers do not impose any additional charges on the investors for placing a TSL order.
A trailing stop loss order is a wise choice for risk management. A trailing stop loss certainly helps in preventing a winning trade from turning into a losing trade. If not that, it reduces the amount of the loss if your trade does not work out.
So, are you ready to give the trailing stop loss order a chance?