Learn the Difference Between Stop Loss & Trailing Stop Loss
Many new traders make the mistake of not following proper risk management techniques. You may have chosen your broker carefully, practised extensively on the demo account, and finetuned your trading plan. Irrespective of how confident you are about your trading strategy, you cannot overlook risk management. Successful traders never do. Consider it a prerequisite for active trading. Among the most effective risk management habits is setting up stop loss or trailing stop loss orders with every trade.
Why Trade with Stop Loss or Trailing Stop Loss Orders?
Markets do not always move as expected. Both stop loss and trailing stop loss orders automatically liquidate your position if the price moves against you by a predetermined amount. This helps trim your losses when the market does not move in the direction you expected. Let’s say you are long on gold, as you expect an uptrend. Suddenly overall market sentiment improves after some leading companies report exceptional results, exerting pressure on safe havens like gold. It is common to feel bullish and expect gold prices to resume its rally, which is what makes you continue holding onto long positions even when the market moves against you. This could mean more losses than you had initially planned for. If you were trading with leverage, the losses would be magnified and could even lead to a margin call.
To prevent holding onto a losing trade, it’s best to set up a stop loss or trailing stop loss order that will automatically close your trade to prevent your losses from escalating. This allows you to consider your risk-reward appetite (how much you are willing to lose for the opportunity to book a profit) even before you open a position. You can set up your stop loss or trailing stop loss order according to this and prevent your capital from being depleted by one unfavourable trade.
The Main Difference Between Stop Loss and Trailing Stop Loss
Ever been in bumper-to-bumper traffic? Every time a car moves 5 inches, the car behind it moves 5 inches. That’s exactly what trailing stop loss does. While the price of a stop loss order remains constant irrespective of how the market moves, the price of a trailing stop loss tracks the market price in one direction. Let’s say you’re long on gold and gold price increases. The trailing stop loss price will also increase. However, when gold prices move against you and decline, the trailing stop loss price remains constant. On the other hand, if you’re going short on gold, your trailing stop loss price will be higher than your order price. In this case, the trailing stop loss price will decline every time the price of gold falls and remain constant when the gold price rises.
Here’s a quick comparison of stop loss and trailing stop loss:
| Stop Loss | Trailing Stop Loss |
| It’s a fixed price order that automatically liquidated your position if the market price reaches a certain level. | It’s a dynamic order that automatically adjusts the stop loss price as the market price moves in your favour. |
| It acts as a safety net, limiting your potential losses. | It is also a safety net that limits your losses on a losing trade but helps lock in profits if the market has moved in your favour before reversing. |
| It sets a hard limit on how much you’re willing to lose. | It builds more flexibility into your trading strategy. |
3 Ways to Determine Stop Loss and Trailing Stop Loss Points
The simplest way is to select a stop loss price that’s between 1% to 3% below your entry point.
This is known as the percentage method and should depend on:
– Your risk appetite: The higher risk you are willing to be exposed to, the higher the percentage.
– Amount being traded: If you’re trading a large position, the percentage can be lower.
Some traders prefer the support method to simply using a percentage. This makes use of technical analysis to identify key support levels that the asset has historically found difficult to breach.
Another common method is using moving averages to smooth out price fluctuations. The stop loss is kept just below a moving average line that signals a potential trend reversal.
Choosing Between Stop Loss and Trailing Stop Loss
Consider the advantages and limitations of both to make an informed decision.
Stop Loss Advantage: It is very easy to understand and implement by new traders.
Stop Loss Limitation: Stop loss has a fixed price, which may result in missed opportunities to book profits in case the market moves in your favour before reversing trend.
Trailing Stop Loss Advantage: It helps lock in profits if the market moves in your favour before reversing.
Trailing Stop Loss Limitation: It could sell prematurely in case of a sudden pullback during an uptrend.
A stop loss can be considered when the market is volatile, while a trailing stop loss is more suitable for markets that are trending. Also, you can use a stop loss to define your maximum acceptable loss. A trailing stop loss is mainly used to lock in profits while still mitigating downside risk.
To Sum Up
- Don’t overlook risk management, even if you are very confident of your trading decisions.
- Both stop loss and trailing stop loss orders automatically liquidate your position if the market price moves against you by a certain amount.
- They help trim your losses when the market moves in the opposite direction to what you expected.
- Setting up stop loss and trailing stop loss helps you build risk management into your trading strategy.
- The main difference is that the price of a stop loss order remains static irrespective of how the asset price is moving, while the price of a trailing stop loss follows the asset price when the market moves in your favour.
- The 3 ways to determine stop loss are the percentage method, the support method, and using moving averages.
- Stop loss is very simple to understand and implement but can result in missed opportunities to book profits.
- Trailing stop loss helps lock in profits if the market moves in your favour but can liquidate your position prematurely in case of a sudden pullback during an uptrend.
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