Trailing Stop

What Is a Trailing Stop?

A trailing stop is a type of stop-loss order that an investor places with a broker to sell a security if its price falls by a set amount from its highest level since the order was entered. Unlike a regular stop order, whose trigger price stays fixed, a trailing stop's trigger price follows the market upward. It never moves back down, so it only tightens as the security's price rises.

How It Works

The distance between the trigger price and the market price can be set in two main ways. It may be a fixed dollar amount, such as $2 below the peak price, or a percentage, such as 10% below the peak. When the security's price climbs to a new high, the trigger price rises by the same distance. When the price drops, the trigger price stays where it was. If the market price falls to or below the trigger, the order becomes a market order (or, in some versions, a limit order) and is executed.

For example, suppose an investor buys a stock at $50 and sets a trailing stop at 10%. If the stock rises to $60, the trigger moves up to $54. If the stock then falls to $55, the trigger stays at $54 and the order does not execute. If the stock drops to $54, the sale is triggered. The investor would have locked in a gain while still allowing for the stock to rise further.

Advantages and Limitations

Trailing stops can help investors manage downside risk without watching prices constantly, and they can protect some profit on a position that has risen. They also remove some emotional decision-making from selling.

However, they have drawbacks. Normal price fluctuations can trigger a sale before a longer upward trend resumes, and when triggered during a fast decline, the execution price may be well below the trigger because of slippage. Trailing stops also do not guarantee an exit price. Understanding how the order type handles volatility and bid-ask spread is important before using one.