Trailing Stop Orders Explained: How They Work and When They Can Help

Trailing stop: quick overview

A trailing stop is an order type where the stop price follows a security’s current market price by a set amount or percentage. The “trailing” feature means the stop price can move as the market price moves in a favourable direction.

For example, if a stock price increases, a trailing stop may adjust upward based on the selected trailing amount. If the stock price later falls, the stop price generally remains at its highest adjusted level rather than moving lower.

Once the market reaches the trailing stop level, the order can be triggered and submitted according to the selected order type, such as a market order or a trailing stop limit order.

Trailing stops can be used as part of a broader approach to managing positions, but they do not constitute investment advice or a guarantee that a specific price will be received when the order executes.

What is a trailing stop?

A trailing stop is a type of stop order designed to follow a security’s price movement. Instead of using one fixed stop price, the stop level can adjust automatically as the market moves in one direction.

For a long position, the trailing stop generally follows the price upward when the share price rises. If the stock price later declines by the selected trailing amount, the order may be triggered.

For example:

• An investor sets a trailing stop using a $5 trailing amount.

• The stock price rises, causing the stop price to move higher.

• The stock price later falls by $5 from the highest adjusted level.

• The trailing stop order may trigger.

The stop price generally does not move downward when the market price falls. This feature allows the order to follow favourable price movement without continuously lowering the exit point.

How a trailing stop order works

A trailing stop order follows a set process:

1. The investor selects a trailing amount

The investor chooses how much room the security has before the order triggers. This can be either:

• A fixed dollar amount

• A percentage of the market price

For example, an investor may set a $2 trailing amount or a 5% trailing percentage.

2. The market price changes

As the market price moves, the trailing stop monitors the security’s price movement.

If the price moves in a favourable direction, the stop price adjusts according to the selected trailing amount.

3. The stop price adjusts

For a long position, the stop price may move higher when the asset price increases.

For example:

• A stock trades at $50.

• A $5 trailing stop creates a stop price of $45.

• The stock price rises to $60.

• The stop price adjusts upward to $55.

If the stock price continues rising, the stop price can continue adjusting upward.

4. The price reverses

If the stock price falls by the trailing amount from the highest adjusted level, the order may be triggered.

The order then follows the instructions selected by the investor. Depending on the order type, this may result in a market order being submitted or a limit order being submitted through a trailing stop limit feature.

The final execution price can depend on factors such as liquidity, market volatility, available buyers and sellers, and overall market conditions.

Trailing stop example

A trailing stop can be easier to understand through a simple example. Assume an investor owns shares of a company purchased at $50 per share and sets a 10% trailing stop.

The trailing stop begins by following the share price. If the stock price increases, the stop price adjusts upward. If the stock price falls by 10% from the highest adjusted price, the order may be triggered.

In this example, the trailing stop does not remain fixed at the original $45 level. Instead, it adjusts upward as the stock price moves higher.

If the stock price reaches $65, the trailing stop may move to $58.50. If the stock price later falls to that level, the trailing stop order can be triggered.

The purpose of the trailing feature is to allow the stop price to follow favourable price movement while keeping a predefined exit point if the market reverses.

However, a trailing stop does not guarantee that shares will sell at the exact stop price. If the market moves quickly or there are limited buyers available, the final executed price may differ from the trigger price.

Dollar vs. percentage trailing stops

When setting a trailing stop, investors may choose between a fixed dollar amount and a percentage-based amount.

A dollar trailing stop uses a specific amount to determine how far the market price can move before the order triggers.

For example:

• A stock trades at $50.

• An investor sets a $5 trailing amount.

• The stop price begins at $45.

• If the stock price rises, the stop price adjusts upward by the same dollar distance.

A percentage trailing stop adjusts based on a percentage of the security’s price.

For example:

• A stock trades at $50.

• An investor sets a 10% trailing stop.

• The stop price begins at $45, which is 10% below $50."

• If the stock price rises, the trailing stop adjusts proportionally. If the stock price rises to $60, the stop price adjusts to $54, since the trail is recalculated as 10% of the new high.

A dollar amount may be easier to understand because the distance between the market price and stop price remains consistent. A percentage amount can adjust based on the security’s price level.

The choice between a dollar trail and a percentage trail can depend on factors such as the asset class, stock price, volatility, and investor preferences.

When might investors use a trailing stop?

A trailing stop may be considered in situations where an investor wants an order to adjust as a position moves in a favourable direction.

Possible uses include:

• Managing a potential exit from an existing position

• Setting a predefined price level for a sell order

• Allowing a position to continue moving upward while maintaining a trailing trigger

• Monitoring positions where market volatility may create frequent price changes

• Supporting a consistent approach to reviewing trades

For example, an investor holding shares of a company may set a trailing stop to create a conditional sell order that follows the stock price if it rises. If the stock price later falls by the selected trailing amount, the order may trigger.

A trailing stop can also be used by investors who want to define an exit point without manually adjusting a stop price each time the market changes.

The way a trailing stop functions can vary depending on the security, order settings, and brokerage platform. Investors may review order details before placing a trailing stop to understand how the trigger price, limit price, and execution process work.

Trailing stops may be used in different types of accounts and across various securities, but they may not be suitable for every situation. Market conditions, volatility, and individual circumstances can affect how the order performs.

Benefits and limitations of trailing stops

Potential benefits

A trailing stop can offer several features that some investors may find useful when managing positions.

Potential benefits include:

• Automatic adjustments: The stop price can automatically move as the market price changes in a favourable direction.

• Less manual monitoring: Investors may not need to update the stop price every time the share price changes.

• Defined exit point: A trailing stop can create a predetermined trigger level based on a dollar amount or percentage.

• Support for risk management: A trailing stop may help investors establish a framework for reviewing potential exits.

Limitations to consider

Trailing stops also have limitations that investors may want to understand.

These can include:

• No guaranteed execution price: The final sale price may differ from the trigger price.

• Potential impact from volatility: Short-term price movements may trigger an order even when the investor’s broader view has not changed.

• Price gaps: If a stock opens significantly lower than the previous closing price, the execution price may differ from the trailing stop level.

• Trail amount selection: A trailing amount set too close to the current market price may result in an earlier trigger.

Understanding both the features and limitations of trailing stops can help investors evaluate how this order type may interact with different market conditions.

Common mistakes to avoid

Trailing stops can have different results depending on how they are set and how the market moves. Investors may consider the following points before placing a trailing stop order.

Setting the trail too close

A trailing amount that is close to the current market price may trigger more easily during normal price fluctuations. Short-term price movements may cause the order to activate before a larger market move occurs.

Ignoring market volatility

Securities with high volatility can experience frequent price changes. A trailing stop may react to these movements differently than it would in a more stable market environment.

Assuming a specific sale price is guaranteed

A trailing stop can create a trigger level, but it does not guarantee the final execution price. The executed price can depend on available buyers, market liquidity, and the speed of price movement.

Not understanding trigger rules

Investors may review how the order works before placing it, including whether the order becomes a market order or a limit order after the trigger occurs.

Forgetting to review order settings

Order duration, trailing amount, limit offset, and other settings can affect how a trailing stop functions. Reviewing the order ticket before submission can help confirm that the selected settings match the intended transaction.

Conclusion: understanding how trailing stops work

A trailing stop order can provide a way for investors to set a moving trigger price that adjusts as a security’s market price changes. Unlike a fixed stop order, the trailing feature allows the stop price to follow favourable price movement while remaining at its highest adjusted level when prices move back.

Trailing stops can have potential uses in managing positions, but they also involve considerations such as volatility, liquidity, execution price, and order settings. Understanding how trailing amounts, trigger prices, and execution rules work can help investors evaluate whether this order type fits their approach to monitoring trades.