Trailing stop loss: should you use it?
There are different ways of managing your open trades in forex, one common way is by using a trailing stop loss. But should you use it?
Going forward, I’ll explain my personal experiences along with some general knowledge about using a trailing stop so that you can decide whether it could be that missing component that needs to make your trading strategy as profitable as it could be.
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What is a trailing stop loss?
A trailing stop is a stop loss that automatically moves/adjusts as the market price travels in your favorable direction. The further price moves within the desired direction (up or down) the trailing stop moves with it until the price retraces and touches it.
How does a trailing stop loss work
The first thing to know is that a trailing stop only working when the PC is on. So if your trading strategy heavily revolves around a trailing stop, then I highly suggest seeking a VPS provider.
SUGGESTION: ICmarkets offer a free VPS if you trade the minimum required lot sizes every month. Failure to do so will charge you $20/ monthly.
Moving on, a trailing stop acts as a ‘tail‘ for the current market price, always keeping its specified distance as the price continues to travel in the profitable direction. However, if the price were to retrace/pullback, the trailing stop loss would not move from where it currently is.
Example how a trailing stop works
A long position (buy) with a stop loss of 50 pips, and a trailing stop of 25 pips. As the market moves up above your entry, the stop loss will automatically move with it pip by pip, maintaining the 25 pips distance.
In other words, as the market price moves one pip in your direction, the trailing stop loss automatically moves up one pip also reducing the initial size of the stop loss. However, if the market price was to retrace, the stop loss would not move.
Please note, a “trailing stop loss size” that is smaller than your “stop loss size” will negate your stop loss size. Referring to the above example (ie: stop loss 50 pips; trailing stop (250 points) 25 pips ). The moment the market price moves one pip in your direction, your stop loss is now 24 pips.
Likewise, with a 60 pips stop loss and 20 pips (200 points) trailing stop, the moment price moves one pip in the desired direction, the stop loss moves from 60 pips to 19 pips.
This is because a trailing stop maintains the specified distance from the current market price that the trader input.
Best trailing stop loss size
With that in mind, it is good to know the volatility of a currency pair before applying a trailing stop loss, or you would risk being stopped out unnecessarily if the stop loss is too tight (small).
Professional traders use indicators, particularly, the ATR (average true range) indicator to know which is the best trailing stop loss size to use.
Video: Know the best place to put your trailing stop loss
Advantages of using a trailing stop loss
- A trailing stop loss can be quite useful especially when it comes to holding a trade for the duration of a trend, specifically, an impulsive move.
- Automatically locks in profit as the price continues to traverse in a desirable direction
- If used properly, it automatically reduces the risk of that particular trade as that open trade goes deeper in profit.
Disadvantages of using a trailing stop
- Though using a trailing stop can be good, a trader must bear in mind that it increases the profitability of your trading strategy. This is because the market will fluctuate often, most time randomly while traveling in the intended direction. As such, with a dynamic stop loss, you are likely to be stopped out, especially if it too small.
- As explained in the previous point, dynamic stop loss has an increased probability of being hit compared to a stationary stop loss.
Automatic trailing stop loss vs Manual trailing stop loss
Automatic stop loss refers to when the stop loss is automatically adjusted with each movement of the market price without a trader’s intervention.
On the other hand, a manual trailing stop loss is one that requires the trader to manually adjust the stop loss himself.
In my personal experience, manual trailing stop loss is more effective and profitable, depending on how you use it. While automatic trailing stop moves as the market moves, it puts the trade at risk of being stopped out, but on the other hand, if a trader ere to anticipate a retracement, then he/ she would not adjust the trailing stop until after the end of the retracement.
This means that manual trailing stops are adjusted where and when the trader deems best thus reducing the likelihood of it being stopped out.
In the defense of an automatic trailing stop loss, a trader can adjust how often the stop loss is moved via “trailing step”.
According to ig.com, a trailing step “dictates how much the underlying market needs to move before your trailing stop re-adjusts. The larger your trailing step, the more the market has to move before your stop is re-positioned, and the less frequently the ‘trailing’ would be performed“.
When should you use a trailing stop loss?
Now knowing as much as needed to know about a trailing stop loss, it begs the question, when should you use a trailing stop loss?
My personal answer to that question would be, “it depends on which trailing stop”. I am not a fan of automatic trailing stop, however, manually adjusting your stop loss per market structure is by far the optimal way of trailing your stop loss.
To be more precise, in an uptrend, for each higher low that the market makes, it would be best to re-positioned your stop loss there. Likewise, for a downtrend, adjust the stop loss per each lower high.
It is important to know the uses and benefits of using a stop loss, or better yet, why you should not move your stop loss no matter what.