Trailing stops are a popular risk management tool used by traders to limit their potential loss. A trailing stop is a type of stop-loss order that is set at a certain percentage or dollar amount away from the market price of a security. As the market price moves in favor of the trade, the stop-loss order is also adjusted to lock in profits. This can be helpful for momentum trading strategies in particular.
Why use them?
One of the key advantages of using trailing stops is that it allows traders to stay in a profitable trade for as long as possible, while still protecting their profits.
For example, if a trader buys a stock at $100 and sets a trailing stop at 5%, the stop-loss order will initially be placed at $95. If the stock rises to $110, the stop-loss order will be adjusted to $104.50 (5% of $110). This means that if the stock suddenly drops to $104.50, the trader's position will be closed, and they will have locked in a profit of $4.50 per share.
Another advantage of trailing stops is that it can help traders to avoid the "fear of missing out" on a profitable trade. Many traders tend to hold on to losing trades in the hope that the market will turn in their favor.
Trailing stops can help traders to avoid this trap by automatically closing a losing trade when it reaches a certain level of loss.
How to use them
There are various methods to determine the placement of a trailing stop. One popular method is to use a percentage of the stock's volatility. For example, a trader may set a trailing stop at 2% below the stock's 10-day moving average.
This means that if the stock's price falls 2% below the 10-day moving average, the trader's position will be closed, and they will have limited their losses. Another method is to use a dollar amount or a fixed percentage of the stock's price. For example, a trader may set a trailing stop at $5 or 2% below the stock's current price.
Another method is to take the realized volatility, add it to implied volatility and then divide the two by 29. That sets a trailing stop that will trigger should price volatility increase beyond levels that were realized or expected.
Despite the advantages of trailing stops, it is important to note that they are not a magic solution to managing risk. Traders should always use a combination of different risk management tools such as stop-loss orders, position sizing and diversification to limit their potential losses.
In conclusion
Trailing stops are a powerful risk management tool that can help traders to lock in profits and avoid larger losses in momentum trades, and other strategies. They can be placed using various methods such as a percentage of the stock's volatility or a fixed dollar amount or percentage of the stock's price.
However, it is important to remember that no single risk management tool is perfect and traders should always use a combination of different tools to manage their risk.