April 02, 2020 |James Messi
What is a trailing stop loss?
A Trailing Stop Loss (TSL) is an advanced order type used by savvy traders of traditional financial instruments (such as, Securities, Equities, Commodities, Foreign Currencies, Options and Futures). This specific type of order mechanism is designed to protect traders against market downside when they enter a long position (buy). A TSL is a step beyond a basic Stop Loss (SL) position where a trader will set an automated sell condition that triggers at a predetermined price. Rather than triggering at a price the TSL will give the trader the ability to condition an automated sell based upon a predetermined percentage below market center. For newcomers that can be a lot to digest so let’s follow along with a practical example.
How it works in practice:
Ray is bullish on Bitcoin, and wants to buy some to profit in the short term. So, Ray heads to his preferred device and logs on to his favorite Digital Asset exchange platform. While all indications point to the price of Bitcoin making an upwards movement, financial markets are still quite unpredictable. So Ray digs deep into the tools of the exchange to find the best order type that captures profits, and that protects his principle investment from unplanned downside.
Follow the trade performance below and the TSL in action ??
STEP 1: Order Opens
Average Bitcoin entry price: $10,000.00
Buy order size: $1,000.00
TSL threshold: 3% below market price ($10,000.00)
Profit target: 10%
STEP 2: Order Closes
Average Bitcoin exit price: $10,600.00
Post trade balance: $1,060
Emotional state of Ray: ?
Discussing the Results:
Ray bought $1,000 worth of Bitcoin at a price of $10,000 per Bitcoin. Ray has also set a TSL condition at 3% below the market price, and he is looking for a total of 10% profit from this open trade. In a perfect world the price of Bitcoin shoots up to $11,000 bringing Ray’s initial investment to $1,100 and achieving his goal of 10% profit. While that would be an exciting result, that isn’t in the cards for this trade. The price of Bitcoin increases by 9%, and the TSL adjusts to the new market center. What that means in practice is Ray just locked in 6% profit on his trade because the TSL follows the market price, and resets it’s trigger 3% below it. It’s a good thing Ray used a TSL, because shortly after the move up the price of Bitcoin crashed back down below his initial purchase price. Without setting a TSL not only would Ray have missed out on realizing profits, but he would have been underwater on his trade.
What does it all mean?
Order types like the TSL can help traders protect their capital from the emotions they experience when participating in live markets. It takes a tremendous amount of practice and discipline to ignore emotional urges when capital is on the line, so using advanced order options can take those difficult decisions out of a trader’s hands. Before using some of the more intricate order types, any beginner should first take the time to learn the basic order options. The Trailing Stop Loss is an effective tool in any traders arsenal, which plays a key role in risk management. Traders that succeed master all of their tools, and understand the best time to use each of them.
Want to see some other unique order types, come check them out!