If you’ve wondered how forex traders maximize their profits in a trending market, one method many traders use is the trailing stop. This type of order trails the market as the exchange rate moves in a direction that favors the position it protects.
Many forex traders will include trailing stop loss and trailing stop limit orders in their trading plan as a money management technique to respond to situations where they have made a profitable trade with unrealized gains. These order types limit forex traders’ potential risk and help ensure that their winning trade does not turn into a loss.
The following article explains what is a trailing stop order and how you can use a trailing order to limit your market risk and let your profits run. Keep reading to find out more about trailing stop orders and how you can apply them to your forex trading.
What Is a Trailing Stop?
To define a trailing stop, you should first be familiar with the stop order. A stop order is an order type that gets executed if the market moves in an adverse direction that will cause your order to be executed at a rate worse than the present market rate.
For example, if you have a long position, then a protective stop order would involve telling your broker to sell out some of all of that position below the prevailing market exchange rate. Conversely, if you have a short position in a currency pair, then a protective stop order would involve buying the currency pair once it has reached a level you select above the prevailing market exchange rate.
While stop orders are generally used to limit losses or protect profits on an existing position, you can also use stop orders without an existing position if you want to initiate a position at a level that is worse than the prevailing exchange rate for some reason.
A trailing stop is a modified stop order that can typically be adjusted by a fixed currency amount, number of pips or percentage move of an exchange rate as the market moves in a favorable direction.
When your chosen criteria are met, the level of a trailing stop order will also generally be adjusted either automatically or manually by a certain amount higher on long positions and lower on short positions. The usual purpose of using a trailing stop is to keep a profitable position in a currency pair open as long as the exchange rate continues trending in its favor.
While all online forex brokers will accept stop loss orders, not all of them will accept trailing stop orders. Accordingly, if this type of order is vital for your trading strategy, you should look for a broker that accepts trailing stop orders.
How Does a Trailing Stop Work?
Trailing stops work for long and short positions, but they must be placed carefully. Depending on the exchange rate’s volatility and the percentage or number of pips in your order, your trailing stop might get executed after a brief market reaction, leaving you without a position even though you were initially right about the exchange rate’s direction.
Some forex traders place a trailing stop order simultaneously when they initiate a trading position. The trailing stop effectively serves as both a money and risk management tool.
For example, if you go long a currency pair, you can immediately limit your losses if you place a trailing sell stop order below the market at the exchange rate level you wish to exit the trade if your position goes against you. Depending on the number of pips or the percentage you specify in your trailing stop order, the trailing stop level on your long position will increase as the market rises.
This practice lets you lock in your original profit and add to it if the market continues to rally. Once the market pulls back, your trailing stop order could be filled, thereby protecting your profit in the trade and turning it from an unrealized gain into a realized gain.
If you instead decide to position yourself on the short side, your trailing buy stop order would be placed above the prevailing market to limit your risk on the upside and cover your short position if the market rallies.
If the market continues to decline, your trailing stop order remains above the prevailing market, but its level would adjust downwards by the percentage or number of pips you specified in your order.
If the market then rallies, your trailing buy stop would be filled to protect your original profit and whatever additional amount depending on how much the exchange rate declined after you initiated the position.
Understanding How to Use Trailing Stops in Forex
Some forex traders choose to use a trailing stop as part of their overall money and risk management strategy. Others may use it on a per-trade basis. There is no right or wrong way to use a trailing stop. It is a tool that can be employed in various ways to fit the needs of the individual trader.
When using a trailing stop, remember that they only move in one direction since they are designed to help traders progressively lock in profits or limit losses. Also, the trailing stop level generally only moves once certain automatic criteria have been met or the trader intervenes to move the order manually.
You will also need to use criteria that make sense for the particular currency pair you are trading. If the pair has low volatility, then you can use a tighter trailing stop. If the pair moves dramatically on a regular basis, then you will want to use a more distant trailing stop. Basically, you want to avoid setting a trailing stop too close to the current market exchange rate since it would be subject to an early execution based on background market volatility.
You can use the average true range (ATR) indicator and the Chandelier Exit strategy to assess the average volatility of a currency pair. This action lets you avoid setting your trailing stop where it will be executed on a mere pullback instead of on a substantial market reversal.
Example of a Trailing Stop
For example, consider the situation where you established a long position in the EUR/USD currency pair at the 1.0500 level, and the market price moves up by 50 pips in favor of your position to 1.0550. Your position is now showing an unrealized gain of 50 pips.
You could place a trailing stop order at 49 pips below the present market level at 1.0501. This would protect your unrealized 50 pip profit from turning into a loss. The trailing stop order will also allow you to continue to profit from the move if the EUR/USD exchange rate continues to move higher.
If the market continued to rise by another 50 pips to 1.0600, then you could move your trailing stop order up to 1.0550. This will let you lock in roughly 50 pips profit while still allowing you to benefit from further rises in the EUR/USD exchange rate.
Trading Forex with Trailing Stop Orders
As a forex trader, one of the most important things you can do is to protect your unrealized profits against an unexpected adverse market move. Once you show a significant gain on a trading position, using a trailing stop makes a lot of sense.
Many experienced traders use a trailing stop order when trading currency pairs, but a key element to using trailing stops successfully is to avoid placing them too close to the current market level so that they end up being triggered by ordinary market volatility.
Also, keep in mind that a trailing stop order is an order to buy or sell a currency pair at an exchange rate that is worse than the prevailing market rate by a certain percentage or number of pips.
Like with a stop loss order, the execution of a trailing stop will generally result in a worse rate than you could have achieved if you had closed the position with a take-profit order instead.
It is also important to keep a few additional things in mind about trailing stops.
Slippage
Like a stop-loss order, a trailing stop is generally not a guaranteed stop level. If the market moves quickly, it is possible for the trailing stop to be triggered at a level that is worse than the original stop rate. This phenomenon is known as slippage and can cause a trader disappointment when it happens. Some online brokers guarantee stop levels to help eliminate the experience of order slippage.
Profit Reduction
A trailing stop will typically result in a smaller profit than if the stop had not been used and the position had instead been closed out at the better level that existed when the trailing stop was entered. Also, when the trailing stop order is eventually executed, it will eliminate any further upside potential of the trade.
Does Not Guarantee Profits
Remember that a trailing stop is not a magic bullet to guarantee profits. A trailing stop will not always protect a position from loss since it may be executed before the position even shows a significant profit. Also, due to the inherent volatility in certain currency pairs, your trailing stop might get filled at a less-than-optimum level and you can suffer even further from adverse order slippage. This situation can leave you with no position in a market you accurately called.
Triggered by False Breaks
You need to be aware of the potential for false breaks that can trigger your trailing stop order. A false break is when the market price moves past your trailing stop level but then quickly reverses and moves back in the other direction that would have resulted in a better level for you to close your position at. This can happen in highly volatile markets, as well as when large currency traders attempt to trigger stops and then take profits sending the market back in the other direction.
Advantages of Using Trailing Stop Orders
The main advantages of using trailing stop orders when trading in the forex market are the reduction of market risk and the protection of profits. These benefits both argue strongly for incorporating trailing stops into most money and risk management plans.
Using strategically placed trailing stops can protect and increase your profits significantly because it helps you safely ride your winning positions to better levels. This process lets you cut your losses short and let your profits run, as the old trading adage advises you should.
Other advantages include the possibility of the trailing stop being a market or limit order depending on your order specifications. The most important consideration for the trailing stop order is the percentage, dollar or pip amount and how much the order will trail the exchange rate.
Should You Use Trailing Stops in Your Forex Trading?
Money management techniques like trailing stops deserve considerably more attention than they usually get from retail forex traders. These useful tools could prevent many newer forex traders from going out of business. The advantages of using trailing stop orders clearly outweigh the disadvantages and could save you a significant amount of money.
Nevertheless, trading with trailing stops requires familiarity with the currency pairs you’re trading so you don’t get stopped out before making a significant profit. Ideally, you should be familiar with the market so your trailing stops don’t get filled prematurely.
The decision regarding whether and how to trade using trailing stops will ultimately depend on how you trade and your risk tolerance. If you’re a conservative trader, then trailing stops would make sense, and you will probably want to position your trailing stops closer to your trade entry point.
In contrast, more aggressive traders with a higher risk appetite and deeper pockets might prefer to either avoid trailing stops altogether or place their stops further from their trade entry point by using a higher percentage or pip amount.
Frequently Asked Questions
What is a disadvantage of a trailing stop loss?
Because of the inherent market volatility seen in certain currency pairs, a trailing stop might get filled at a less-than-optimum level on a sharp pullback. You can suffer even further from adverse order slippage, which can leave you with no position in a market you accurately called.
Do professional traders use trailing stop loss?
Many professional strategic forex traders do use trailing stop orders, although large-scale professional market makers might use mental stop levels instead to avoid exposing their order levels to others.
Is 5% a good trailing stop loss?
It depends on the market traded, but most traders would find that too close to the current market exchange rate and hence subject to an early execution based on background market volatility. You can use the ATR indicator to assess the average volatility of a currency pair so that you can avoid setting your trailing stop where it will be executed on a pullback instead of on a reversal.