When is a Trailing Stop Used by Forex Traders?
Many times, traders are faced with the dilemma of whether to close a profitable trade or keep it, in an attempt to get more.
In such situations, there are two scenarios that can unfold: if they leave the position open, it might reverse and eat away all the profits; or they might close the trade for a profit and see it extending the move and feeling bad for missing out on the potential profit.
In such situations, a trailing stop might just be the solution. It is a method of protecting gains by allowing a trade to remain open and continue to profit as long as price continues in the right direction but closing the trade if the price starts moving against you by a specified number of points.
Once you set a trailing stop, it will automatically track the evolution of price and advance if it is favorable. That's in contrast to the fixed stop loss, which has to be manually reset in order to progressively lock in profits.
Trailing Stop Dilemma: A tight Stop or Wide Stop?
The big question when using trailing stops is the size of the increment used: a tight stop or a wide stop? A tight trailing stop might get you out of the market too soon, and you'll miss any trading profits that may unfold unless you re-enter. A wider stop might allow more breathing room for price fluctuations, but it also exposes you to greater loss potential.
The motivation behind using trailing stops is to let your profits run. In a non-volatile trend, a trader will be able to make outstanding profits, until the trend eventually reverses, and the stop is executed.
However, this requires repetition, discipline and experience in reading markets and identifying when a trailing stop would be appropriate. It also depends on your trading style, philosophy, strategy etc.
Study Case: How to Use Trailing Stop?
A trader decides to go long the USDJPY pair with 5000 units at 104.00 and sets a 2% trailing stop order to secure position. This means that if USDJPY declines by 2% or even more, the trailing stop order will be triggered, limiting losses. Over the next month the USDJPY pair increases in value, reaching 105.50, thus gaining 1.44%.
The trader is enjoying the profit he has registered for the moment, but expresses concerns that the USDJPY pair might retrace its gains. As his trailing stop remains in place, if the USDJPY pair declines 2% or more, say within the next week, the trailing stop will be triggered. The trader might decide to tighten the trailing stop to 1.50%, allowing his trading position more room to run.
Over the next few trading sessions, USDJPY pair appreciates further, reaching 106.00, but then suddenly tumbles 1.50% within a single trading day to 104.40. This 1.50% decrease in price would trigger the trailing stop and assuming the order was executed at 104.40, the trader would lock-in 40 pips of profit.