Getting a grasp of trailing stop loss orders can be baffling for new traders in the market. Effectively implementing a trailing stop loss or a trailing stop limit might be even more complicated and might even seem next to impossible. However, they have their benefits.
We are going to discuss all about trailing stop loss and trailing stop limits orders as simply as possible for everyone’s benefit in this article.
Upon reaching the trailing stop loss level, this type of order creates a market order (at market price and close position).
According to a trailing stop limit order, on the other hand, upon reaching the stop price, a limit order will be sent. That instructs the filling of the order only according to the present or better limit level. Trailing stop limits are risky for fast declining prices but grant more control to traders.
How Does a Trailing Stop Loss Order Work?
Generally, a trailing stop loss will move along with security prices. The stop loss level continuously keeps readjusting with rises in the market even though there is no fixed price.
Among the various ways of calculating trailing stop loss, the simplest and most popular method is setting the stop at a convenient distance from the highest peak or the lowest trough in case you are short. That causes the stop level to be continuously increasing along with any movement of the market.
Another popular trailing stop option is moving averages. Once you enter a trade, the moving average tends to follow the trend. The stop loss takes effect once the trade hits the moving average. That’s your ideal exit window.
Stops Protecting Profit
Trailing stop loss orders are often called profit protecting stops. As long as the price action stays favorable for your trade, they will keep moving with the security. However, as soon as the trend is reverted, trailing stop losses come into effect.
For this reason, most trend-following strategies use trailing stops. You would be in for the long trends with the stop loss level and the trend synchronized with the trade exit window activating as soon as the trend is reversed.
Trailing Stop Limit and Trailing Stop Loss Orders
Let’s check out the two different types of orders that can be used when the market reaches the stop loss level now that we have a clear understanding of trailing stop losses:
These orders are activated and sends a market order as soon as the market hits the predetermined stop loss level. They are usually immediately filled since there are no conditions with market prices for the execution of the order.
Stop Limit Orders
A limit order is sent out once the stop level is hit. These orders are only filled by the limit price or better. If you reach your stop level when you are long in a trade long enough, the trade would be exited at or above the limit price.
If you are short in a trade, on the other hand, and the stop level is reached, you would get out at or below the limit price.
The specific level that sends out the limit order once reached.
Once this level is reached, a limit order with a purchase instruction at the limit price.
Stop orders don’t place a market order when the stop level is reached. This is the most significant difference between stop orders and stop limit orders. A limit price is set instead, and the security will be sold only if your broker finds a seller/buyer at or better than your specified price.
Trailing Stop Loss Vs. Trailing Stop Limit
Trailing stop limit might often seem an obviously better option due to the greater flexibility it provides. However, stop limit orders carry more risks even though they entitle more direct control over trades.
Consider this example:
Suppose there’s a free-fall for one of the securities you are trading. Your order might not be entirely executed in such a case. If your broker was able to sell only a small portion of the shares before the price fell below the limit level, until the security’s price rises above the limit level again and your broker finds willing buyers, your order will not be filled.
On the other hand, the likelihood of market orders going through is much higher. There is, of course, the risk of not finding willing buyers at a suitable price and experiencing a loss much greater than you expect, foresee, or prepare for. However, if you’re trading in liquid markets, this issue would not present itself so often.
Which One is the Better Choice?
There’s no specific better choice when it comes to trailing stop loss and trailing stop limit orders. Limit orders provide more control over trades but do bear additional risks.
Limit orders should only be used by those willing to sell securities only at a suitable price and willing to wait for the price to come back up over the limit level if it drops below the predetermined limit.
On the other hand, those who intend to ensure closing their position immediately after stop loss gets triggered should go for trailing stop loss orders. The people who believe the security’s price is not getting back to the standard it fell from and tend to avoid risks should choose trailing stop loss orders.
There are risks and benefits for both trailing stop loss and trailing stop limit orders. Your projections and forecasts for certain security and nature of the engaged trade typically determine the usage of these orders.
Setting the stop loss at an appropriate price is definitely important, along with choosing the order type to use. This ensures execution of the order and triggers the trailing stop loss only when your trade is moving against your best interests or profit.