Trailing Stop Loss: Meaning, Example and How to Use It

A profitable stock trading portfolio involves exploring every profitable trading opportunity while minimising losses at every level. Trailing stop loss is one of traders' most frequently used tools to maximise profits and minimise losses. Explore this blog to learn how trailing stop loss works and how it can help you have a sound trading portfolio. 

What is Trailing Stop Loss?

A trailing stop loss is a trading tool used to lock in profits and limit losses on a trade.  Unlike a regular stop loss, which is set at a fixed price, a trailing stop loss moves with the market price. Traders set a trailing stop loss with a specific percentage or amount below the highest price the stock reaches. The trailing stop loss strategy is particularly useful for traders who want to capitalise on upward market movements while having a safety net to protect against sudden downturns.

How Does a Trailing Stop Loss Work?

A trailing stop loss works by automatically adjusting the stop price as the price of a stock moves up, helping traders lock in profits while protecting against losses. Here’s how it works,

When traders set a trailing stop loss, they specify a percentage or a fixed amount below a stock's current market price. 

As the stock price increases, the trailing stop loss increases, maintaining the set distance but on the other hand, if a stock price falls the trailing stop loss kicks in to maintain profitability levels.  The trailing stop loss can be set as a percentage of the stock price or in rupee terms.

Suppose a trader buys a stock at Rs 120 and doesn’t want to lose more than Rs 5 on that trade, he can set stop loss at  4% of the trade or put in rupee terms at Rs 5. 

Learning How to Set Trailing Stop Loss with an Example

To implement trailing stop loss, you would need to decide on a percentage or a fixed amount below the current market price. Here’s a simple example to explain it further. 

Suppose Ankush wants to buy stock of Reliance Industries with a trailing stop loss of 3%.

• Initial Purchase - Stock of Reliance Industries Ltd bought at Rs.2945.

• Set Trailing Stop Loss - Set at 3%.

• Initial Stop Loss - Initially, the stop loss is set at Rs. 2856.65 (3% below Rs. 2945).

Now, the trailing stop loss order will move as per the stock price movement. 

• Stock Price Rises - If the stock price rises to Rs.3100, the trailing stop loss moves up to Rs. 3007 (3% below Rs. 3100).

• Stock Price Falls - If the stock price then drops to below Rs. 3007, the trailing stop loss is triggered, and the stock is sold at Rs.3007, locking in the profit of Rs 62 (3007-2945).

Key Features of a Trailing Stop Loss

A trailing stop loss is an essential technical analysis tool for protecting your trading capital from market volatility. Here are its key features highlighted. 

• The stop-loss price automatically moves up as the stock price increases, helping to lock in profits without needing manual intervention.

• It helps protect profits by selling the stock when the price falls to the trailing stop level, thus securing gains made during the price rise.

• It minimises potential losses by triggering a sale if the stock price drops to the trailing stop level, preventing further declines.

• Traders do not need to constantly monitor the stock’s price, as the trailing stop loss adjusts automatically to market movements.

• Traders can choose the trailing amount or percentage based on their risk tolerance and trading strategy, allowing customisation to their needs.

• The tool also adds trading discipline by enforcing predetermined exit points, which helps avoid emotional decision-making.

When to Use a Trailing Stop Loss?

A trailing stop loss is best used when traders want to protect their gains while allowing for potential further profits. It is advantageous in volatile markets where prices can fluctuate widely. 

Traders should consider using it when they have made significant gains on a stock and want to lock in those profits while still giving the stock room to grow. It is thus helpful for traders to automate their exit strategy, allowing them to focus on other opportunities without constantly monitoring the stock. 

Advantages and Disadvantages of Using a Trailing Stop Loss

The use of trailing stop loss is to use it as a caution against volatile markets. Therefore, it is important to understand the advantages and disadvantages of trailing stop loss for effective implementation. Here is a brief analysis of the same. 

Advantages of trailing stop loss

• A trailing stop loss helps to secure profits by moving with the price with an endless profit potential and limits losses at the same time. 

• This tool helps traders capitalise on market movements without constantly monitoring them, making it suitable for day traders and traders with time constraints. 

• Trading with trailing stop loss removes the emotional bias from the trade and allows traders to make rational decisions.

• You can customise your risk management strategy based on your risk parameters, allowing your goals as per your trading plan while keeping your trading capital safe.

Disadvantages of trailing stop loss

The key disadvantages of using trailing stop loss are,

• Stocks with low volatility may not benefit from a trailing stop loss, as price movements may not be significant enough to activate the stop loss.

• If the trader is not able to set trailing stop loss order accurately, it can lead to potential losses which the trader will have to bear.

• Traders may not be able to set trailing stop-loss orders for specific stocks or ETFs due to restrictions imposed by certain brokers as per their policies.

• In a volatile market, the trailing stop loss might be triggered too early due to short-term price fluctuations, potentially causing traders to miss out on further gains

• Frequent triggering of trailing stop loss can be frustrating and may lead to over-reliance on the tool reducing the ability to gauge the market movements effectively. 

Conclusion

A trailing stop loss is a valuable tool for traders aiming to maximise profits while managing risks. Using a trailing stop loss order is especially useful for seasoned traders with multiple trading positions to manage and limited time to focus on each. Trailing stop loss orders allows traders to maximise the profit potential from any trade as well as provide a safety net against market volatility.