Trading in the stock market is laden with uncertainties. The market conditions can force an investor to be confident regarding a particular price surge. But who knows when a change in government policy, a war or a protest might pull the stock prices down. To mitigate such risks, there are various stop-loss strategies designed to prevent massive losses. One of such strategies is the trailing stop loss strategy.
What is the trailing stop strategy?
Trailing stop is one of the stop-loss strategies that allows an investor to set a maximum value or a percentage of loss for a trade. It triggers the selling of stocks if the share price falls below a certain percentage or value.
How does the trailing stop loss work?
To understand how this stop-loss strategy works, consider the following data of stock purchased:
Purchase price= Rs 200
Trailing amount= Rs 20
Last price at the time of setting trailing stop= Rs 205
Price at which the stocks will be sold = Rs 185 (205-20)
Now, due to unavoidable circumstances the value of the stock price falls from Rs 205 and drops to Rs 185. The moment the price drops to Rs 185, the stop loss order fixed at that price will automatically sell the stocks.
If the stock price increases from Rs 200 to become Rs 210 then it will also drag the trailing stop along with it. In case the stock price after reaching Rs 210 begins to drop, the new trailing stop price at which the stocks will be sold is Rs 190. Thereby, minimising investor’s losses. The stop-loss price remains unchanged unless the price of the stocks moves above Rs 200.
Trailing stops can be used with stocks and in the derivatives market that supports traditional stop-loss orders.
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Trailing stop is one of the stop-loss strategies that allows an investor to set a maximum value or a percentage of loss for a trade.
When can the trailing stop loss be used?
It can be used in the below situations while trading.
- If investors are short selling their stocks, then the trailing stop-loss should be placed above the market price.
- If investors are holding the securities with the expectation that the price is going to rise then the trailing stop needs to be placed below the market price.
Pros and cons of trailing stop loss strategy
Pros
- This stop-loss strategy does not put a cap on profits. The traders can hold their securities as long as the market price of stocks does not fall below the set price or percentage.
- The trailing stop prices act as loss-protecting stops that sell the shares automatically after the market price drops below the predetermined price or percentage. It eases the stress of investors even if they at that moment are not trading, as the shares would sell automatically.
- There are no additional charges imposed on investors by the stockbrokers for placing a stop-loss order.
- This stop-loss strategy is flexible since investors can customise their risk management plan by choosing any percentage as trailing stop loss.
Cons
- Investors need to be careful while selecting stockbrokers as they do not allow investors to put stop-loss orders for some particular shares and exchange-traded funds.
- Stop-loss indeed prevents losses but it also erodes a trader’s ability to analyse the market further impacting the buying and selling of stocks.
- The timing of the trailing stop order is crucial when the market price of a stock falls rapidly.
- Setting a stop-loss order becomes complicated if an investor fails to determine the right stop-loss order. If he/she sets a price or percentage too low for the market fluctuations thereby incurring massive losses. This happens when the market is extremely volatile.
- Trailing stop-loss orders pull traders out of the market too soon. The price of the stock might be undergoing a market correction and not a dip in price. To avoid falling in such a scenario the prices should be fixed at points that are far away from the current price that will not reach easily.
Lastly, a trailing stop loss strategy can be an efficacious tool and should be used judiciously, but it is also essential for all traders to analyse market conditions before setting up this strategy.
