Stop-loss is an effective tool to minimise risk. A regular stop-loss is set at a particular price point. If the price falls below this predetermined level, the trading terminal closes off your position by executing a market order.For instance, suppose you bought a stock at Rs 100 and set the stop-loss at Rs 97. Later during the day, the price falls. If the stock falls below Rs 97, your trading terminal will execute a market sell order. Hence, your loss would be limited to Rs 3 (or slightly more) in this case.Remember, a market order executes at the prevailing price (refer to chapter 2.6). Hence, you may not be able to sell the stock at exactly Rs 97. If the stock price rapidly falls, the order may execute at a price significantly lower than Rs 97. Barring this, it will be at or around Rs 97 levels in most cases.As you can see, stop-loss is an effective tool to protect against downside risk. However, if the stock goes up, it fails to protect your gains. Let's get back to our above example to understand what I mean.Suppose the stock went from Rs 100 (entry price) to Rs 105. Later, during the session, it falls to Rs 97. Even though your actual loss is Rs 3 (Rs 100 - Rs 97), your notional is actually Rs 8 (Rs 105 - Rs 97). So, the natural question in your head would be -- is there a way to protect my profits. Yes! You can use a trailing stop-loss.
What is trailing stop-loss?
A trailing stop-loss is a type of stop-loss order that protects your downside risks and locks in profits if the trade moves in your favour.Here, instead of setting an absolute figure as stop-loss, traders set a predetermined loss percentage. Hence, if the market moves in your favour, the stop-loss level also rises.Let's get back to our example to understand how a trailing stop-loss order works.Suppose instead of a regular stop-loss, you had set a trailing stop-loss at 2%. When the price increased to Rs 105, your new stop-loss would now be Rs 102.90. Hence, a sell order would only be triggered if the stock falls below this level. This assures you a profit of Rs 2.9.Trailing stop-loss works the best in a trending market. It lets you ride the momentum till the stock eventually falls.
Advantages of using trailing stop-loss
- Locks in profit if the prices are rising.
- The order is flexible. Hence, if you feel the stock is volatile, you can increase your trailing stop-loss percentage from 2% to 5 or even 10%.
- Extremely useful in day trading, as you don't have to monitor price movement constantly.
- There is no extra cost for placing a trailing stop-loss order.
Disadvantages of using trailing stop-loss
- As mentioned earlier, there is no guarantee that your position will square off at stop-loss. Remember, fast-moving markets and overnight positions can push the execution prices much lower than the stop-loss price.
- It may not be the best option if the stock is highly volatile, as it will trigger a sell order even if the overall trend is in the direction of your trade.
