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Reader Asks: How and When Should You Use a Trailing Stop?

Sean Hyman (March 11, 2009)


Wednesday, March 11, 2009

By Sean Hyman One of your fellow readers sent me a great question the other day that I wanted to share with all of you. She wrote to me…

“I am new to the Forex market, just started late in November. I’m catching on but then again every time I think I have it, something else will happen that takes the wind out of my sails. How excited I was when I made five hundred dollars in a few minutes, and then lost a thousand just as fast. I just wanted to ask about the “trailing stop,” what is it and how does it work?”

Indeed – we’ve all been there. Every Forex trader has felt that rush of earning a quick profit, only to lose it the next day.

But the good news is that it’s possible to manage your trading account so you can keep trading, lock in profits on your winners, and most importantly reduce your losses on those trades that go against you.

And yes, trailing stops can help with that. But let me go on record right now as saying a trailing stop is one of the most MISUSED orders out there in Forex.

At first glance, it appears that if you put in an order and a stop with a trailing stop, then it seems like you’re guaranteed to capture a profit. However, this is not always the case.

So let’s take a step back and talk about the difference between a regular typical stop and the trailing stop.

Your Run-of-the-Mill Stop-Loss in Forex

The easiest way to describe a stop is that it’s an order to get you out of a trade you’re before your trade hits a certain level.

Sometimes its described as, “the level where you know you’re wrong about the trade,” or the level where you’re already starting to lose money and you want to “stop” the pain to your account.

Say I wanted to buy USD/JPY at 98.00 with a stop at 97.00, then that means if the pair moves backwards against me 100 pips, then I want out. It would be an order that closes me out of that particular trade with a loss. However, it ensures that I preserve the rest of my capital to trade another day.

Professionals constantly think about protecting their capital. That’s why many are successful overall, even after choosing losing trades (after all, nobody is going to get it right 100% of the time). In fact, I often say “risk management” is the main difference between retail investors and professionals.

As I often say, it’s usually best to never risk more than 1-5% of your account balance on any one trade. Some traders simply calculate the percentage of loss on each trade so they can only lose 1% or 2% of their account on any one trade. They ask themselves, “how much can I afford to lose on each trade?” Then they make sure they only risk so much on any one trade.

Other traders eyeball a place on the chart to look for the technical level to bail out of each trade. However, even that trader needs to think about how much risk percentage wise that it would take on the account if they were wrong.

So that’s a regular, run of the mill, typical stop. (For more on stop-losses, make sure to check out my full “Why You Need an Exit Strategy I” article from this past Monday.)

So What’s a Trailing Stop Then?

Then what is a trailing stop? It’s the order for when you are “right” on a particular trade.

A trailing stop does NOT replace a regular stop-loss. In fact, you use a trailing-stop in addition to your regular stop-loss. It’s really two separate instructions for the exact same trade.

When you place a trade, you always add a stop-loss. Then your trading software will automatically close out your trade if the price reaches your desired stop-loss.

However, the trailing stop tells the exact same stop-loss to move forward by a certain amount.

Here’s where people get confused: They think ANY advancement
is a profit for them. However, they are thinking about the pair moving and not where their stop is moving from. In reality, your pair still has to move a certain amount for you to make a profit, whether your stop-loss is moving.

Here’s an example: Remember, earlier we were buying USD/JPY at 98.00 with a stop at 97.00. If we add in a 30 pip trail to that, each time the pair moves 30 pips from where we entered the trade, then the stop-loss ALSO advances by 30 pips.

So if the pair moves from 98.00 to 98.30, then our stop-loss moves from 97.00 to 97.30. Yes, our stop moved, but you will notice that it doesn’t mean we are profitable on the trade. In fact, we are still 70 pips away from breakeven. Our trail-stop has to “hop” in 30 pip increments three times for us to profit.

Two Correct Ways to Use a Trailing Stop

How do you solve this problem so your trail stop guarantees you lock in profits? There are a couple of ways.

1. Place a trail stop that is wider than the distance between your entry and stop level. Example: Buy USD/JPY at 98.00 with a 50 pip stop at 97.50. Now I also add in a trail stop order for 60 pips. Since my trail stop is wider than the distance of my regular stop, if it moves up, it ensures at least some profit. In this example, once the USD/JPY pair moves from 98 where I got in, to 98.60, the trail stop kicks in and “hops” instantly up 60 pips from 97.50 up to 98.10. Therefore, I’m for sure 10 pips in the profit in this example.

2. Only use a trail stop once your trade has moved enough that you’re at break even, even if your stop-loss is triggered. Once you’re at breakeven, any trail-stop will lock-in profits. Example: So if I took that same USD/JPY trade and when the pair moved from 98.00 to 99.00, I manually moved my stop up to breakeven at 98.00. Then I can add in a trail stop of ANY size, then it will surely lock in profits IF the pair continues upward by the amount of the increment we chose.

Now Here’s WHEN You Should Use the Trailing Stop!

So when should you be using these anyway? Because it’s not a good idea to use them all the time. (However, a regular stop should be used on EVERY order to protect your trading account.)

Here’s the answer. Trail stops are BEST used when a strong momentum type of move is happening. It’s when you see the price going so strong that the angle of the trend slope is very steep. This is where the trail stop is best used.

Why? It is most likely to kick in the trail and move up. It also shows a strong trend. If you’re in a strong trend, you want to soak as much as you can out of it. Thus you don’t want to “cap” your gains with a limit order, so you place a trail stop instead.

When do you NOT want to use a trail stop? You don’t want to use a trail stop when the pair is in a sideways range (no trend) or when it’s in a very mild trend. Think “trailing stops” when you see huge, momentum (fast, steep) moves in the pair.

In other words, you use a trail-stop when you are in a pair and the profits are coming very quickly in a short span of time.

If the pair is in a sideways range, then just put in a regular stop and a limit where the pair comes to the other side of the range.

Also, some pairs tend to be quicker movers than others. For instance, GBP/JPY is known to be a quick mover much of the time. It can clear hundreds of pips each day in a small span of time.

So a “fast moving” pair is ideal for trail stops. However, a “tame” pair like CHF/JPY typically wouldn’t normally be a great pair to use a trail stop with because its moves are not that quick and fast typically. However, if it ever were to fit that criterion, then by all means, you can implore the trailing stop.

So I hope this helps to clear things up.

One final note: Practice using your first couple of trailing stops on your broker’s demo account. That way you aren’t risking hard earned dollars while you make sure you are getting the order in right.

Best Regards,
Sean

P.S. In case you haven’t heard, we have the oldest Forex-trading service designed for retail investors just like you. Several times a week, our Money Trader services releases trading bulletins with all the information you need to place each Forex trade (including any stop or trailing stop-losses!). If you’re already a subscriber, please be sure to check out your Money Trader Trading Handbook for more information on stop-losses and how to use them to manage the risk in your trading account. Not a member yet? Click here to see what you’ve been missing.

Sean Hyman, “Professor FX” and Long-Time Currency Analyst Explaining How You Can Succeed in the Currency Markets.
Sean Hyman spends his days teaching his fellow professionals in the industry how to trade the $4 TRILLION currency market. Now he brings his 15 years of financial experience to you. From long-term currency strategies, to quick FX-trading moves usually reserved for the professionals, Sean will tell you everything you need to know to succeed in the currency markets.

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