What Is a Trailing Stop?

What Is a Trailing Stop?

A trailing stop is a stop-loss order that moves with the market price, protecting profits on a trade from a market reversal.

Flying a plane is easy, but landing it is the challenge. Similarly, profitable trading is all about the exit. It can be hard to watch a market reverse course and wipe out all—or even a significant chunk—of the profits from a formerly winning trade. But in a trending market, how do you know when to exit?

That's when you need a trailing stop. The trick is finding a technique that strikes the right balance between letting a profitable position run and protecting profits from a reversal without getting stopped out by the market's normal ebb and flow. This is especially important in trend-following strategies, when the idea is to follow the market as long as it's trending.

Key Takeaways

Trailing stops are meant to protect profits in a winning trade by tracking the market, preventing big gains from turning into small ones and small gains from turning into losses.

Finding the right balance is crucial. A stop that's too tight may result in you getting stopped out by the regular ups and downs of the market, while one that's too loose could mean giving back most of a big win.

Trailing stops are best suited for trending markets, when the idea is to stick with the trade as long as it's moving in your favor.

Understanding Trailing Stops

A stop order exits a long or short position when the price hits a certain level. A trailing stop is simply a stop order that automatically follows—or trails—the market once the price of a security has initially begun moving in a favorable direction. If the market later reverses direction, the stop price will remain fixed, and the exit order will be placed if the stop price is hit.

The goal is to protect existing profits on the trade. Otherwise, if you leave only your initial stop in place or have no stop in place, a once-winning trade could turn into a loser. That's a losing strategy overall.

The concept is simple enough. But deciding where to place the trailing stop is challenging. If you set the trailing stop too close to the current price, normal price swings that don't constitute a true reversal could stop you out, leaving money on the table. If the stop is too far away, a true reversal could end up chewing up more of your potential profit than necessary—or even all of it.

The answer depends on several factors, including the time frame you're trading, the volatility of the market you're trading, and personal choice.

Trailing stops help eliminate emotion when exiting trades, perhaps the most important part of trading.

Types of Trailing Stops

There are several types of trailing stops, each with different ways of determining where to place stops as the market continues to move. You might use a defined percentage above or below the current market price, sometimes aligned with Fibonacci retracement levels in long-term trades.

Another option is a specific dollar amount above or below the current market price. Or you could base it on the average true range over n number of days multiplied by y number of days—for example, set a stop equal to five days away from the most recent close, with each day represented by the average true range over the past 14 days. In a trend-following strategy, this is a useful way of letting the market run without getting stopped out by normal price swings that don't amount to a change in the trend.

You could also use a close above or below a specific moving average, such as the eight-, 20-, or 50-day trailing stops. Previous support or resistance levels work too—for instance, if the market recently found support or resistance during a healthy pullback to a certain price level, a break below or above that level would be a strong exit signal, so place a stop there.

Trailing Stop Example

Let's say NVIDIA Corporation (NVDA) breaks to a new high at $100 and you buy. You decide you're willing to risk a 5% loss on the initial entry, so you put the first stop at $95.

The stock then moves to $110. Your position is showing a profit and you decide 10% is an appropriate trailing stop given the stock's volatility. So you set the trailing stop at 10%, which at this point would be $99 (110 - (110 × 0.10)).

As the price continues to rise, the trailing stop automatically rises with it. When the price reaches $120, the trailing stop is at $108, ensuring at the very least that you'll secure a profit of 8%.

The stock eventually closes as high as $135. At that point, your stop would be at $121.50 (135 - (135 × 0.10)). Three days later it crosses below that level before closing at $118. Your stop is triggered at $121.50, so you secure a profit of 21.5%, assuming perfect execution.

It will be months before NVDA trades above $135 again, and, in the meantime, it will fall as low as about $90. If you had set a looser stop—say 20%—you would have been stopped out at $108, meaning what had been a 35% profit ended up at 8% (instead of 21.5% with a 10% stop).

In this way, you've not only secured a solid profit with a 10% trailing stop, you've freed yourself up to pursue other prospects while NVDA trades sideways for an extended period.

Pros and Cons of Trailing Stops

Trailing stops have clear advantages and drawbacks. They lock in profits by protecting existing gains on a trade while still giving the market room to run, helping you stick to the adage to 'let your profits run.' They reduce emotional trading by forcing you to think clearly about exits before entering a trade and set rules based on those decisions. Most trading platforms automate basic trailing stops, so you don't have to manually adjust as the market moves. They're especially useful in trending markets for trend-following strategies, though they're also handy for protecting against false breakouts from rangebound markets.

The Cons

On the downside, making sound decisions for trailing stops requires hard thinking about the market and a basic understanding of technical analysis. Like any trading strategy, you can borrow one, but if you don't understand its logic, it may not fit the market you're trading.

They're not suited for all market stages or time frames—different exits work better for most day trading unless it's limited to trend days, and swing trading isn't about riding trends, so price levels or other criteria are often better. If set too close, even moderate volatility can cause premature exits from a still-trending market.

The Bottom Line

Trailing stops offer a powerful way to lock in profits while letting winning trades run. By tracking the market while it moves in a favorable direction, a well-placed trailing stop ensures you don't give back significant gains to reversals. They also help automate exits and avoid emotional decision-making.

But trailing stops aren't always the best choice for exiting a trade. They work best in trending markets and are generally not well-suited for day trading. They are also best deployed by people with at least a basic understanding of technical analysis.