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What is Trailing Stop Loss order and how it can help traders to protect and grow investments? With Examples

Updated on May 31, 2013
Trailing Stop Loss
Trailing Stop Loss | Source

How to use Trailing Stop loss?

What is Trailing Stop Loss Order?

Trailing stop loss order is an innovative type of stop loss order that helps to protect your investments while maximizing your returns. It is mainly used in long positions or when the investor buys something and wants to protect this trade from downward risk. Technically, it is a stop loss order that is set or predetermined by the investor on a fixed amount or percentage below the current market price of the underlying stock or commodity.

Trailing Stop loss order works differently and tends to be more beneficial over normal stop loss orders. Smart investors, working in volatile markets like to use this strategy to get a good return without fear of market downs.

For instance, if an investor is doing option trading on SPY and wants to buy put and then, put a trailing stop loss to protect from the decay or downward price movement of put. As seen in the below picture, he bought one SPY Aug 17'12 135 Put for a price of US$ 293. After the purchase, he sets a trailing stop loss of 15%. This gives a stop loss at US$ 252.

15% of 2.92- Trailing stop at 2.52
15% of 2.92- Trailing stop at 2.52 | Source

Trailing Stop Loss and how it operates:

Trailing stop Loss Order is a mobile stop loss which can move when the conditions are favorable and remains constant in adverse conditions. To understand more, read the above example in 2 different situations:

1. When the stock price goes up. Trailing stop loss order moves the stop loss value when the price moves against it or upward in this case. Hence, if the underlying stock or commodity is moving up, the trailing stop keeps on moving upward and secures the profit. For instance, in above SPY case, when the price of put moves from 2.92 to 2.98, the trailing stop moves from 2.52 to 2.59.

2. When the stock price goes down. Trailing stop loss order maintains the same stop value when the price moves towards it. Thus, it helps to protect the losses. For instance, in above case, if the price of put moves from 2.92 to 2.85, the trailing stop will remain same at 2.59.

Thus, trailing stop loss order helps to capture good returns while minimizing the losses. This order can be used in volatile conditions by investor to protect their investments while still waiting for higher returns on their capitals.

However, in case of extreme rare conditions in the trading market, it might be possible that the market rapidly moves down and the automated trailing stop loss is not triggered. This can lead to significant loss of capital. Hence, there are risks associated with automated orders too like trailing stop loss and investors need to be fully educated before starting any investment.

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