A trailing stop loss allows traders to set a predetermined loss percentage that they can incur when trading on a financial instrument. It plays an efficient role in managing risks and providing profit protection. Consequently, these are also known as profit-protecting stops. When the price of a financial instrument rises or falls, the stop price moves up or down accordingly.
When an investor takes a long position, a stop price is set at a fixed distance below the market price of a financial instrument. It puts a cap on the amount of loss that a trader can suffer. But, they do not set a ceiling on the potential gain that can arise due to the increase in market price. Hence, it allows traders to take away profits until the market turns against them.
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Features of Trailing Stop Loss
A trailing stop loss has the following features –
- Trailing stop loss orders are established to function automatically with stockbrokers and their investing software.
- Technical indicators can be used to put in a trailing stop loss.
- Contrary to a regular stop loss, a trailing stop loss moves according to changes in price levels of a financial instrument.
- This type of stop loss order efficiently helps in managing both risk and trade.
- This day-trade order maintains a certain level of discipline while trading in financial markets.
Trailing Stop Loss Example
Let’s say that an investor, Mr B buys 200 shares of ABC Company at Rs 50 each. He places a trailing stop loss order for 10% so that if the market price of these shares drops below 10%, (Rs 5), they will automatically be sold off.
Even though Mr B expects the share price of ABC Company to rise, some unfavourable conditions might lead to the opposite. In that case, the trailing sl would allow him to limit his losses to 10% of the initial investment. Thus it protects him from incurring heavy losses.
On the other hand, if the share price of ABC Company rises to Rs 100 each, the trailing stop loss order will only set off when the market price falls below 10% of Rs 100 (Rs 10).
When Can Trailing Stop Loss be Used?
Trailing stop losses are used in many situations while trading. Some of them are as follows –
- When investors have an option to put in a trailing stop loss with their stockbrokers or if the investing software offers such a facility. A stop loss order can also be put in manually, but traders who keep a check on their investments regularly should avoid it.
- When traders are convinced that they’ll only incur a certain percentage of loss in case the price of a financial instrument drops. Nevertheless, when the market price rises, they’ll be able to benefit from the gains while having precaution against heavy losses.
Advantages of Trailing Stop Loss
The advantages of trailing stop losses are discussed below –
- This type of stop loss orders does not put a ceiling on profits. The traders will hold their positions as long as the market price of a financial instrument does not fall below the set percentage.
- Profit-protecting stops are designed to sell the shares automatically after the market price drops below the predetermined percentage. So, when the market price is going down, the traders need not worry if they’re not present in their trading platforms.
- This order type prevents traders from taking reckless decisions based on their emotions. It helps them to concentrate on their predetermined objectives.
- No additional charges are imposed on investors by the stockbrokers for placing a stop loss order.
- This type of stop-loss order is elastic in nature. Traders are allowed to customise their risk management plan by choosing any percentage as trailing stop loss.
Disadvantages of Trailing Stop Loss
Although this type of stop-loss comes with the above-mentioned merits, there are some demerits associated with it. They are as follows –
- There are some stockbrokers in financial markets who do not allow investors to put stop loss orders for some particular shares and exchange-traded funds.
- Gradually, traders lose the ability to efficiently analyse various market dynamics. They face great difficulty in taking major decisions pertaining to the buying and selling of financial instruments.
- When the market price of a stock falls rapidly, the trailing stop order might not be placed in time. Hence, the trader cannot be assured of the price of a stop-loss order.
- It becomes complicated to trade with a stop-loss order when stock prices are too volatile. If the trader sets a percentage that is too low for the market price fluctuations, he/she will be obliged to bear significant losses.
A trailing stop loss can prove to be an efficacious tool when used judiciously. But it’s essential for all traders to assess the market conditions before setting up this type of stop loss order.