Using a Combination of Stop Loss and Trailing Stops

You might already know the value of ensuring adequate risk management while trading the financial markets. But before we go into combining different risk management techniques, here’s a refresher on the two popular ones we’re discussing in this article.

A stop loss order ensures that your position is automatically closed at a pre-defined price should the market move in an unfavourable direction. This limits the losses you might have accrued by leaving the position open for longer. It also helps keep emotions from influencing your trading decisions. After all, it is only human to hope that the market will reverse and turn your losses into gains. But more often than not, the losses add up and the price rebound might not justify staying with the trade.

A variation of this risk management technique is the trailing stop. Here, rather than setting the stop loss order at a specific price, it is set at a percentage or dollar (or any other currency you might be using) amount below the current market price. Now, when the price rises, the trailing stop moves up with it. But when the price drops, the stop loss level stays in place to protect you against the downside. The benefit of trailing stops is that they allow you to book profits when the market is moving in your favour. It can also be an effective way to cope with volatile markets.

Have you used both these risk management methods while trading? Most likely, you’ve used either stop loss or a trailing stop for a specific trade. But did you know that you could enhance your trading strategy by combining the two? Here’s what you should know about using stop loss orders in combination with trailing stops.

1. Combining Stop Loss with Trailing Stop

These two orders can work together to form a powerful risk management or exit strategy. This is because while a stop loss order protects your trades if the market immediately moves against you, a trailing stop can help lock in gains when the market moves favourably and then the price trend reverses.

Firstly, it is important to understand your risk appetite when setting this combination of orders. For instance, if you don’t want to lose more than 5% of the funds invested in the trade, you could set your stop loss at 5% below the current market price. You can then place your trailing stop at 5.5% below the market price. Now, if the asset price rises, the trailing stop will move up and might go beyond the stop loss level, making it redundant. But if the asset price falls, your order will get closed automatically at the 5% stop loss level.

The benefit is that if the market continues to move favourably, the trailing stop level keeps rising with each price move upwards, keeping the stop level at 5.5% below the ongoing price. So, even if the market moves unfavourably at some point, you might just end up earning a profit when the trailing stop level is triggered. In the worst case scenario, you will at least break even.

2. How to Use the Stop Loss/Trailing Stop Combination

Let us understand how to use this combination with an example. Let’s say a trader wants to go long on Company A with 500 shares at a purchase price of $100 per share. Now it’s time to set the stop loss and trailing stop orders. The trader decides to set the stop loss at $95, while setting the trailing stop at 5% or $5 below the current market price.

After the position is opened, the share price moves up to $102. The trailing stop automatically moves up to $97 to stay at 5% below the current market price. This cancels out the stop loss order. If the share price continues to move up, the trailing stop will follow to stay at the 5% below market price level.

Now, if the share price begins to fall, your trade will be closed at $97 per trade, securing the trader a profit of $1,500.

However, it is important to remember to accommodate for the typical price fluctuations while setting the trailing stop level for a specific stock. You can do so by spending time studying the stock and its price movements before entering a trade. This will give you an idea of the usual fluctuations the stock witnesses on a normal trading day. Also, remember to stay updated on the latest news regarding the company that could impact its share price. Similarly with currency trading you would conduct thorough research and analysis with your fundamental and technical analysis before you open your trade.

Key Takeaways

• Stop loss orders involve setting a specific dollar (or any other currency) amount at which an open position will be automatically closed.
• Trailing stops involve setting the stop at a specific percentage or dollar (or any other currency) amount below the current market price.
• Stop loss and trailing stop can be combined for a single trade to strengthen risk management and lock in gains.
• It is best to study the asset you choose to trade before attempting the combination to understand the usual price fluctuations during a typical trading session.

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