It is estimated that about 80% of the modern trading volume is a result of automated trading. This consists not only of high-frequency trading but retail trading too. In automated trading, trailing stops are an automated approach to managing risk in a trading account. While retail forex trading isn’t comparable in size with high-frequency trading, the prospect of running automated systems has tempted traders. With time, automated trading software called expert advisors appeared.
However, almost all trades must have an entry, a stop loss, and take profit. The take profit must exceed at least 1:2, with higher numbers preferred. In instances where the market keeps on moving in the right direction, many traders can make the mistake of closing trades too early, looking for other opportunities. This is where trailing stops come into play.
What is a Trailing Stop?
Trailing Stops also referred to as trailing stop-loss, is a special type of trade order. Here, the stop-loss price is not set at a single absolute number. Instead, it is set at a certain dollar amount or a certain percentage below the market price.
When the price goes up, the trailing stop is dragged along with it, until the price stops going up, after which it remains at the level it was dragged to. It is thus the best way for traders to automatically protect their trading accounts from an investment’s downside while locking in the upside.
Why do Traders Use Trailing Stops?
Trailing Stops can help traders better manage a position. It’s an ideal way to protect capital to make the most out of any strong trend. It is thus considered as a very conservative approach for traders to protect their capital in their trading account. The currency market is considered volatile and may swing higher or lower based on no news at all. It can trip stops placed at a psychological level. Trailing stops can filter the market noise, establishing an emotional balance in the trader’s mind while trading.
Trailing Stops Setup Example – EUR/USD Pair
To better understand how setting up a trailing stop works, we shall take the example of the EUR/USD price action. This will help traders in understanding the strategy and allow them to use trailing stops to capitalize on a trade.
Here, the EUR/USD pair formed a diamond reversal pattern when it was last above the 1.18 mark. Traders are required to wait for the diamond formation to break lower. Eventually when it does, it has a measured move. This is similar to other classic technical analysis patterns such as head and shoulders and wedges.
At this point, traders have to make a decision between booking the entire position or to use trailing stops to make the most of a possible trend. It should be remembered that the measured move of any pattern is just a representation of its confirmation. This means that it merely tells us that the reversal pattern is in place. The market, on the other hand, may or may not continue trending, but could continue consolidating.
A trader can thus eliminate the risk of being caught on extended consolidation areas, avoiding fees and commissions for it, if they use trailing stop orders. They can also position themselves for a potential strong trend in the process.
In the above chart, the trader books half the profits at the measured move and trails the stop for the rest. The first trailing stop order is represented by nr.1 on the chart. In this situation, the best way to make the most of a trend is to simply trail the top after every candlestick. In other words, they can move the stop-loss order to the highest value of the previous 2 candlesticks. The fourth bearish candlestick, after the break, triggers a stop-loss order, marked as 2 in the chart above. Trailing the original short trade is still in place. It has a stop-loss at 1.1549. Traders would lower the stop to position nr. 8 if this candlestick closes without triggering the stop –loss.
Using Trailing Stops has many pros as well as cons for a trader. These are described in the section below.
Pros of Using Trailing Stops
- One of the biggest advantages of using trailing stops is making the most of a trend. The trend still remains in place, with the “stop” in positive territory after the bearish break (9 days) with nine candlesticks.
- Using Trailing Stops can protect a trader’s trading count from any vicious spikes that can threaten potential profits.
- The trading decision cannot be influenced by any type of human emotion. All that the trader is required to do is to wait patiently for the close of the trading day, after which they trail the stop to the next level.
- Traders release the much-needed margin in their trading accounts by booking half the profits on a measured move.
Cons of Using Trailing Stops
- Trailing Stops aren’t always helpful as even the forex market spends a lot of time consolidating.
- It’s a well-known fact that over 40% of the forex market is traded in ranges. This means that trends as shown in the above EUR/USD example do not appear very often. In this case, the trailing stop is useless as traders can book only half of the potential profit, just to see the rest of the profit eaten up when the market reverses.
- The execution of a trailing stop can be considered as another drawback. This is especially true if a trader is day trading. During the publication of some major news, the execution can differ significantly once the stop order is approached by the price action.
Trailing Stops can thus be considered as a great tool for money management. They can prevent the effect of emotions on trading and helps them focus on the next trading opportunity and setup. Hence they can avoid opportunity costs. As seen above, the pros overcome the cons and can have miracle outcomes for traders using more and more trailing stop orders.