Understanding the Importance of Trailing Stop-Loss

Stop-loss orders put a cap on potential losses for investors. It allows them to protect their trading capital and avoid huge losses. While there is the traditional stop-loss order, investors also rely on stop-entry and trailing stop loss orders. Beginners must take advantage of different stop-loss orders to avoid significant losses and reap better returns. Let us discuss what trailing stop loss is in this blog in detail.

What is Trailing Stop Loss?

You might be familiar with a traditional stop-loss order. It allows the investor to automatically sell the security when the price of an asset drops to a certain level. The traditional stop-loss is fixed and offers no flexibility. Contrary to the fixed stop-loss order, trailing stop loss offers much-needed flexibility to investors. The value for automatically selling the asset is defined as a percentage of the market value.

When the market value of the security drops by the percentage determined by the trailing stop-loss order, it is automatically sold. However, when the asset price moves up, the trailing stop-loss also goes up, thus offering flexibility to investors. The trailing stop-loss order remains at the same level when the asset’s price falls. Profits are maximised as the stop-loss level goes up when the market is in the favour of the investor.

How Does a Trailing Stop Loss Work?

Now that you have understood the meaning of trailing stop loss, let us discuss how it works. This type of stop loss order moves according to the changes in the market value. It automatically sells the security when the market value of the asset drops by a certain percentage. When the market value of the asset moves up, it follows the price at a fixed distance.

The best part about this type of order is its movement when the market value of the asset falls. When the market value of an asset falls, the trailing stop loss remains static. As a result, the potential loss for the investor is capped. When the market price of the asset reaches the stop-loss value, it triggers a sale order.

Trailing Stop Loss Example

Let’s understand the concept of a trailing stop loss with an example. Suppose you entered a market position by purchasing stocks at a rate of Rs 200. You’ve selected the trailing stop loss at 20%. This means that when the price of the stock hits Rs 160 (20% of 200 = 40), a sale order is triggered. However, the value will increase if the market price of the stock rises.

For instance, if the market price of the stock hits Rs 300 later on, the value for automatic sales will be Rs 240 (20% of 300 = 60). As the stock’s value rises further, the stop loss will adjust accordingly. It’s crucial to note that this stop loss won’t change when the stock’s price falls from its initial value of Rs 200.

When Can Trailing Stop Loss be Used?

Trailing stop loss strategy can help investors in different scenarios. It is particularly beneficial for volatile markets or assets. When there is uncertainty regarding price movements in the market, investors can cap their losses with the help of this order type. However, it would not impact the profits for the investors, as it moves up when the asset’s market value rises. Investors can protect their trading capital by placing these orders.

You can use a trading platform provided by your broker to place this order. This is the perfect choice when you want to limit your loss by a certain percentage but want to enjoy unlimited gains. Some investors still adjust their orders manually based on price movements. Such investors can rely on this tool for increased flexibility and automation.

Advantages of Trailing Stop Loss

The tool allows investors to implement an effective risk management strategy. You can limit your loss on a particular investment by a certain percentage with this order. However, you will enjoy unlimited gains when the asset price rises. It is much better than traditional stop-loss orders, which remain static even when the asset’s market value rises. You don’t have to manually adjust your order with this feature.

It also allows investors to pay less attention to market price movements. Since the order will adjust automatically to the market movement, it removes the need for rigorous monitoring. It also prevents investors from making compulsive or emotional decisions in the market. It is perfect for beginners in the stock market who might not make timely exits by themselves.

Disadvantages of Trailing Stop Loss

While placing a trailing stop loss has some benefits, there are some risks as well. You must be aware of the downsides before placing orders. Its biggest disadvantage can be observed in a highly volatile market showing rapid price movements. In such a case, there might not be ample time for automatic execution, thus leaving the investor at risk. When orders are not executed timely, it might lead to higher losses.

Recommended Read: Understanding the Share Market

Some investors tend to rely completely on these orders. As a result, they might lose their ability to analyse market movements and make informed decisions without the support of technology. Not to forget, not all brokers in India allow this facility. It is important to check for the facility before choosing your broker. Also, do not set the percentage too low. It might trigger a sale immediately after purchasing the asset, assuming the market value falls quickly.

Conclusion

Trailing stop loss orders are perfect for investors who want to limit their losses. While limiting your potential loss, the trailing stop-loss order allows you to enjoy unlimited gains. Since the trailing stop-loss moves up when the market value rises, it is better than traditional stop-loss orders. You can also consult your stockbroker regarding the trailing stop-loss facility.