A trailing stop order is a type of trade that helps you lock in profits or limit losses as a stock’s price moves. Unlike a traditional stop-loss orders, a trailing stop moves with the price, adjusting automatically if the stock goes up. If the price drops by a set amount or percentage, the order triggers a sale. This lets you stay in a trade longer while still protecting yourself if the market turns. A financial advisor can help you decide when and how to use trailing stops as part of a broader investment strategy.
What Is a Trailing Stop Order?
A trailing stop-loss order automatically adjusts as the price of a security moves in your favor. Instead of setting a fixed stop price, you set a stop that “trails” the market price by a specific percentage or dollar amount.
If the asset’s price rises, the stop price rises with it. However, if the price begins to fall, the stop price remains unchanged. The position sells once the market price hits the trailing stop, triggering a market order.
This type of order is especially useful for investors who want to lock in profits on a rising stock while still protecting against downside risk.
How to Set a Trailing Stop Order
Setting a trailing stop order involves choosing the amount — either as a percentage or a fixed dollar value — by which the stop price will trail the current market price. This value determines how much of a price drop you’re willing to tolerate before the order is triggered.
For example, say you buy a stock at $100 and set a trailing stop loss order with a $5 trailing amount. If the stock rises to $120, your stop price moves up to $115. If the price then falls to $115, the trailing stop is triggered, and a market order is executed to sell the stock. The stop price only adjusts upward (for a long position) as the stock price rises.
As another example, let’s say that you buy a second stock at $50. This time you set a trailing stop as a percentage (10%). If the stock climbs to $70, then the stop price moves to $63 (deducting 10% from $70, which is $7). And, if the price drops to $63, the order gets triggered. But, if the stock keeps going up, the stop keeps following, locking in higher potential gains.
Most brokerage accounts allow you to choose whether the trailing amount is in dollars or a percentage. And they offer real-time tools to monitor and adjust your order.
Trailing Stop Order: Pros
Trailing stop-loss orders offer a range of advantages for investors looking to automate exit strategies and manage risk more effectively. Here are four common benefits you should consider:
- Automatic risk management. Trailing stop orders adjust with market movements, allowing investors to lock in gains while still providing downside protection. Once set, the order doesn’t need to be actively monitored.
- Profit preservation. As a security’s price increases, the stop price moves up accordingly. This allows investors to participate in gains without having to manually reset stop-loss levels.
- Emotion-free decision making. By using a preset rule, investors avoid making emotional or impulsive selling decisions during periods of volatility or unexpected news events.
- Works in trending markets. Trailing stop orders are particularly effective in trending markets where prices steadily rise or fall. This allows investors to ride gains without frequent intervention.
Trailing Stop Order: Cons
Trailing stop orders also come with drawbacks that can affect the timing and execution of trades. Here are four common drawbacks that you should keep in mind:
- No execution price guarantee. Because a trailing stop becomes a market order when triggered, the final execution price may be worse than expected, particularly in illiquid stocks or during rapid price changes.
- Premature execution in volatile markets. Short-term fluctuations can trigger the stop before a long-term trend plays out. This can result in missed opportunities if a stock rebounds.
- Requires strategic calibration. Setting the trailing distance too tight may lead to frequent stop-outs, while setting it too wide may allow significant losses. It takes experience and strategy to find the right balance.
- Doesn’t replace regular review. While trailing stops automate exits, they don’t eliminate the need to regularly review your overall investment strategy, market conditions or changes to your financial goals.
Frequently Asked Questions
Can I Use a Trailing Stop Order on Any Stock?
Most publicly traded stocks allow trailing stop orders, but availability may vary by brokerage. Some thinly traded or volatile stocks may not be ideal due to execution risk.
How Should I Choose My Trailing Stop Distance?
The trailing stop distance should reflect your risk tolerance and the volatility of the asset. Tighter stops may suit active traders, while wider stops may be better for long-term investors.
Do Trailing Stop Orders Work After Hours?
Most trailing stop orders are only active during regular market hours. Orders may not trigger or execute properly in after-hours or pre-market sessions, depending on your brokerage’s policies.
Bottom Line
A trailing stop order could help you protect profits and limit losses without watching the market all the time. It moves up with the price of a stock and locks in gains if the price starts to fall. This can position you sell at the right time, but it also carries the risk of selling too soon in a choppy or volatile market.
Investment Planning Tips
- A financial advisor can help you identify investments and manage risk for your portfolio. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- If you want to diversify your portfolio, here’s a roundup of 13 investments to consider.
Photo credit: ©iStock.com/fizkes, ©iStock.com/fizkes, ©iStock.com/shapecharge