Many traders freely place a basic stop loss with every trade they enter, but trailing stops can seem more complicated and may be used less often, if at all. The purpose of a stop loss is simple to understand – a stop loss is intended to limit the trader’s potential loss should the market move against him.
But what if your position is advancing favorably and you want your stop loss to follow your open position as it advances? There are generally two reasons why you’d want to do this: to place a stop loss at a breakeven level (preventing any loss at all), or to exit at a profit when the current trend reverses.
This is what “trailing stops” are all about. A trailing stop is essentially a stop order that follows your open position as it advances. It seems like a simple concept, but there are generally two different ways to trail a stop: automated OR manually-placed stops.
Automated Trailing Stops
Many futures trading platforms come equipped with auto-trailing stop functionality. They often give you a choice of determining the distance between stop, (e.g. 3, 5, 10, or more ticks). Once your position starts moving in your favor, typically you’ll see the stop moving along with it.
The automated trailing stop is a nifty hands-free platform feature. However, it does have at least two major drawbacks:
Drawback 1 – Volatility: If volatility picks up, its fluctuation range (up and down swings) may widen, potentially closing out your position even if its overall movement is heading in a favorable direction.
Drawback 2 – Electronic Error: Only stop and limit orders rest on a commodities exchange. An order that rests on an exchange will likely be triggered in the event that your trading platform fails. But it you set an automated trailing stop for a trade, that stop will most likely rest on your computer. If your computer freezes or if your internet connection fails, then your trailing stop is no longer in effect, placing your trade at risk.
Manually-Placed Trailing Stops
This is perhaps the most accurate way to trail a stop, and it’s one that will likely rest on the exchange as you are using stop orders. Manually-trailed stops are generally quite accurate and perhaps the biggest drawback can be the trader himself or herself. In other words, you have to have a reasonably sound trailing strategy. If you’re not familiar with this concept, then you probably haven’t thought much about it. So, we’ll go over this next.
Two Primary Reasons to Trail a Stop
Reason 1 – To Set a Breakeven Level
This is perhaps the most fundamental reason to trail a stop–to let winners run and limit the likelihood of loss. Some traders set their stops at breakeven (calculated to include trading costs) and just leave it in place, hoping the trade will continue in a favorable direction.
Reason 2 – To Exit the Market When a Trade’s Directional Bias is No Longer Valid
Pay attention to the last part of the sentence: “when a trade’s directional bias is no longer valid.” So, when is a trade no longer valid? If you have a reason, meaning you’re using some kind of calculation, metric, or indicator, then apparently, you’d want to place your trade at that level.
For instance, here’s a trailing stop example based on market swing lows:
Gold Futures (GC) – 1-Hour Chart November 28 to December 4, 2019
A long position was entered at [1], and a stop loss was immediately placed at [2]. Three sessions later, the gold market has a short-term swing low at [3], so our hypothetical trader trails the stop manually a few ticks below that level. The reasoning is that any violation of that low might invalidate the trader’s long bias. Another swing low is established at [4] followed by a breakout (the trader moves the stop to a few ticks below that level). Finally, the trailing stop is placed under the swing low at [5], a level which in a matter of hours is triggered once price violates that low at [6]. Our hypothetical trader is now out of the market holding a profit.
The Bottom Line
Trailing stops can be really useful, but they should follow a logical course based on a predetermined strategy. Automated stops may be consistent, but they can’t think for the trader. Manual stops may be less efficient, but they often allow you to fine tune your exits, a nuanced approach that sometimes can make a big difference when you’re looking to make the best of your position.
Please be aware that the content of this blog is based upon the opinions and research of GFF Brokers and its staff and should not be treated as trade recommendations. There is a substantial risk of loss in trading futures, options and forex. Past performance is not necessarily indicative of future results.
Be advised that there are instances in which stop losses may not trigger. In cases where the market is illiquid–either no buyers or no sellers–or in cases of electronic disruptions, stop losses can fail. And although stop losses can be considered a risk management (loss management) strategy, their function can never be completely guaranteed.
Disclaimer Regarding Hypothetical Performance Results: HYPOTHETICAL PERFORMANCE RESULTS HAVE MANY INHERENT LIMITATIONS, SOME OF WHICH ARE DESCRIBED BELOW. NO REPRESENTATION IS BEING MADE THAT ANY ACCOUNT WILL OR IS LIKELY TO ACHIEVE PROFITS OR LOSSES SIMILAR TO THOSE SHOWN. IN FACT, THERE ARE FREQUENTLY SHARP DIFFERENCES BETWEEN HYPOTHETICAL PERFORMANCE RESULTS AND THE ACTUAL RESULTS SUBSEQUENTLY ACHIEVED BY ANY PARTICULAR TRADING PROGRAM.
ONE OF THE LIMITATIONS OF HYPOTHETICAL PERFORMANCE RESULTS IS THAT THEY ARE GENERALLY PREPARED WITH THE BENEFIT OF HINDSIGHT. IN ADDITION, HYPOTHETICAL TRADING DOES NOT INVOLVE FINANCIAL RISK, AND NO HYPOTHETICAL TRADING RECORD CAN COMPLETELY ACCOUNT FOR THE IMPACT OF FINANCIAL RISK IN ACTUAL TRADING. FOR EXAMPLE, THE ABILITY TO WITHSTAND LOSSES OR TO ADHERE TO A PARTICULAR TRADING PROGRAM IN SPITE OF TRADING LOSSES ARE MATERIAL POINTS WHICH CAN ALSO ADVERSELY AFFECT ACTUAL TRADING RESULTS. THERE ARE NUMEROUS OTHER FACTORS RELATED TO THE MARKETS IN GENERAL OR TO THE IMPLEMENTATION OF ANY SPECIFIC TRADING PROGRAM WHICH CANNOT BE FULLY ACCOUNTED FOR IN THE PREPARATION OF HYPOTHETICAL PERFORMANCE RESULTS AND ALL OF WHICH CAN ADVERSELY AFFECT ACTUAL TRADING RESULTS.