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Learn

Using a Combination of Stop Loss and Trailing Stops

How do you make sure you are using strong risk management while trading? One smart way is to combine your stop loss order with a trailing stop loss, and more.

Disclaimer: This article is an educational guide to CFD trading and the financial markets and should not be considered as advice. Trading CFDs is high risk. Always ensure you understand the potential risks and rewards associated with trading before you trade.

 

 

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.

Did You Know?

Trailing stops might not protect your trades when the asset price moves dramatically. For instance, if you have set the trailing stop at 7% below the current market price but then the price suddenly drops 20%. In this scenario, the trailing stop does not have the chance to be triggered. So, your position does not get automatically closed at the 7% level. But stop loss is set at a specific price, which will get triggered even if the price drops 20%. This is why combining stop loss orders with trailing stops can be a good risk management strategy.

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.

Did You Know?

Moving Averages (MA) and Average True Range (ATR) are the most commonly used charts while determining trailing stop levels. For short-term trends, the trailing stop is often placed with the 20-period MA with 2 ATR. For medium-term trends, the 50-period MA can be used with 4 ATR. For long-term trends, the 200-period MA is often used with 6 ATR.

 

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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Investing in CFDs involves a high degree of risk that you will lose your money due to the use of leverage, particularly in fast moving markets, where a relatively small movement in the price can lead to a proportionately larger movement in the value of your investment. This can result in loses that exceed the funds in your account. You should consider whether you understand how CFDs work and you should seek independent advice if necessary.

ADS Securities LLC (“ADSS”) is authorised and regulated by the Securities and Commodities Authority (“SCA”) in the United Arab Emirates as a trading broker for Over the Counter (“OTC”) Derivatives contracts and foreign exchange spot markets. ADSS is a limited liability company incorporated under United Arab Emirates law. The company is registered with the Department of Economic Development of Abu Dhabi (No. 1190047) and has its principal place of business at 8th Floor, CI Tower, Corniche Road, P.O. Box 93894, Abu Dhabi, United Arab Emirates.

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ADSS is an execution only service provider and does not provide advice. ADSS may publish general market commentary from time to time. Where it does, the material published does not constitute advice, or a solicitation, or a recommendation to a transaction in any financial instrument. ADSS accepts no responsibility for any use of the content presented and any consequences of that use. No representation or warranty is given as to the completeness of this information. Anyone acting on the information provided does so at their own risk.