Last Updated on 14 February, 2022 by Samuelsson
Understanding a trailing stop loss can be difficult if you are new to the markets. For beginner traders who are already struggling with various different order types, the two types of trailing stop losses can be a hassle to maneuver.
A Trailing stop loss order creates a market order [close position at market price] when the trailing stop loss level is reached. On the other hand, a trailing stop limit order will send a limit order once the stop price is reached, meaning that the order will be filled only on the current limit level or better. Trailing stop limit orders offer traders more control over their trades but can be risky if the price falls fast.
Let’s first have a look at trailing stop losses in general, and then go on to exploring whether a stop limit order or a stop order is the best choice for a trailing stop loss!
How a Trailing Stop Loss Works
Trailing stop losses move along with the price of a security. Simply put, there is no fixed price for a trailing stop loss, but the stop loss level readjusts itself continuously with the rising market.
There are many ways you can calculate the trailing stop loss. One way is to simply set the stop at a certain distance from the highest high, or lowest low if you are going short. In that way, the stop level is continuously increased as the market moves, thus becoming a trailing stop.
Moving averages are also commonly used as trailing stops. In the image below you can see how we entered a trade, and the moving average followed along with the trend. Once the moving average was hit, the stop loss was effectuated, and we exited the trade!
Trailing Stop Loss
Profit Protecting Stops
People often call trailing stop loss orders profit protecting stops. This is because they will move along with the security as long as the price action is favorable to your trade. However, they will come into effect as soon as the trend reverts.
This is also the reason why trailing stops are used mostly with trend following strategies. With a stop loss level that rises or falls with the trend, you are in for the long trends, while the trade is exited as soon as there is a reversal of the trend.
Example of Trailing Stop Loss
Suppose you purchase 1,000 shares of a security at $50 and set a trailing stop loss 50 cents below the maximum price [$50 at time of purchase]. If the price keeps on falling and hits $49.50, the trailing stop will trigger and an order will be made on your behalf to sell your 1,000 shares at market value.
However, if the price of the security rises to $52, then the trailing stop loss will move along with the maximum price of the security to $51.50 [50 cents below the maximum price]. Now, even if the price dips to $51.50 and you trigger your stop loss, you will still roughly make a 3% profit on your trade.
Trailing Stop Loss Orders and Stop Limit Orders
Now that we have covered what a trailing stop loss is, we will have a quick look at the two different order types you can use when the market hits the stop loss level.
1. Stop Orders
The stop order is an order type that immediately sends a market order when the market hits the set stop loss level. Since a market order has no conditions as to what price it may be executed at, it is typically filled immediately.
2. Stop Limit Orders
If you use a stop-limit order, once the stop level is reached, a limit order will be sent out. A limit order is an order that will only be filled at the limit price or better.
Thus, if you are long in a trade and your stop level is reached, the trade will only be exited at the limit price or higher
Conversely, if you are short in a trade and the stop level is reached, you will only get out of the trade at the limit price or lower.
So for the stop limit order, there are two levels you need to keep track of:
Stop Level: This is the level where the limit order is sent out.
Limit Level: Once the stop level is hit, a limit order with the instruction to buy at the limit price is executed.
In other words, the major difference between a stop limit order and a stop order is that the latter does not place a market order when your stop level is triggered. Instead, you set a limit price, and the security will only be sold if your broker is able to find a buyer/seller at the price you have stated or better.
Here is further reading that might be of interest.
Candlestick Guide: How to Read Candlesticks and Chart Patterns
Swing Trading Guide – How to Start and learn to be a Swing Trader
Algorithmic trading -The COMPLETE guide
Example of Trailing Stop Limit
Let’s say that you purchase 1000 shares of a security at $50 and you set a stop loss 50 cents below the maximum price. The limit is placed 20 cents below the stop loss.
Once again, let’s assume that the price of the security goes to $52 before falling back to $51.50 which triggers the stop loss. Your broker will now automatically generate a limit order to sell the security. Instead of selling it at the market price, the order will now state that the security can be sold as long as the broker can find a buyer for the security at or above $51.30 [20 cent limit].
Trailing Stop Limit vs. Trailing Stop Loss
From the examples above, it may seem like a trailing stop limit is the obvious choice due to its greater flexibility However, do remember that although limit orders allow you to have a lot more control over your trades, they also carry additional risks.
A perfect example of this would be that if a security is in a free-fall, then the entirety of your order may not be executed. In the aforementioned example, suppose the price of the security kept falling and your broker was only able to sell 700 of your shares before the price fell below $51.30, which is below the limit level. In this case, your order will not be filled until the price of the security once again rises to $51.30 and your broker is able to find willing buyers.
Market orders, on the other hand, have a much larger chance of going through. Of course, there is the risk that you will not be able to find buyers at a suitable price and experience a loss that is larger than your expectations. However, if you trade liquid markets this very seldom becomes an issue.
Which is the Winner?
In short, there is no correct answer to which order you should use. Limit orders should generally allow you to exercise more control with an added risk. They should be used by those who are only willing to sell a security at a suitable price and are willing to wait if the price dips below their limit to rise back up.
Trailing stop loss orders are for those who want to make sure that their position closes as soon as possible once the stop loss is triggered. People who are particularly risk-averse and believe that the price of the security is not going to go back up once it falls should also opt for the trailing stop loss order.
Bottom Line
Both the trailing stop limit and the trailing stop loss have their advantages. Their uses will vary according to the nature of the trade and your projections for that particular security. Just remember that although the order type is important, what is more important is that the stop loss is set at an appropriate price. That way, you can make sure that your trailing stop loss only triggers when the trade is going against you for certain.
We’ll examine both the Trailing Stop and Trailing Stop Limit order types, which have as their key component the trailing amount. For a long stock position, this trailing amount is a value beneath the prevailing market price.
Study Notes:
In this lesson, we’ll walk you through how to set up a Trailing Stop Limit order using TWS Mosaic.
- We’ll define the difference between Trailing Stop and Trailing Stop Limit order types
- Show you how to create the Trailing Stop orders in TWS Mosaic
- Show you where you can locate the Trailing Stop orders within the Activity panel
Trailing Stop and Trailing Stop Limit Order
We’ll examine the Trailing Stop and Trailing Stop Limit order types, which have as their key component the trailing amount. For a long stock position, this trailing amount is a value beneath the prevailing market price.
Suppose you bought a stock some weeks ago, and it’s showing a nice profit. Even though you still expect its price to continue to rise, you want to do the prudent thing and run a stop just in case you’re wrong. The Trailing stop order can help. This type of order allows you to define a maximum loss on an open position, while allowing profits to run.
What is a small difference between the Trailing and Trailing Limit order types?
Just like with a regular Limit order, the Trailing Limit order will not execute at a price below the designated limit price. On the other hand, a regular Trailing Stop order becomes marketable when the stop price is triggered.
Let’s first take a closer look at the Trailing Stop by showing you how we can set up an order on the TWS Mosaic platform.
Creating Trailing Stop orders in TWS Mosaic
From the Portfolio page in the Monitor window, we’ll select FB for Facebook. Since I’m long this stock, I will select to Sell it, then enter the amount of shares I want to sell.
Once this is done, from the Order Type dropdown menu, you will see listed the TRAIL and TRAIL LIMIT types. For this example, we’ll select Trail.
The Order Entry panel now displays two additional fields – STP and TRAIL for the Stop and Trailing values, respectively.
Because the Trailing amount will adjust higher, the Stop price should not be set lower than the value of the current market price of the stock less the Trailing amount.
In fact, you do not have to enter a value in the Stop input field, which means that the Stop will activate should the market price fall to the distance below the share price at the time of entry by the value of the Trailing amount.
In other words, a $50 stock with a Trail of $1, for example, would start to execute should it touch $49.
In this example, *note that this is our stock’s current market price.
Now, I’ll set a $1.00 Trail, but leave the Stop value alone.
I am now ready to Submit this order and generate an Order Confirmation, which will display what we’ve set out to do – that is sell shares using a Trailing amount of $1.00. effectively activating a stop beneath the live market price by that amount.
View the order details in the order tab within the Activity panel.
The live order is displayed, and the Stop price is calculated as the market price less the Trailing amount when the order was transmitted.
Should the share price rise, the stop price will also rise. But it will not fall when the share price declines. Should the share price fall to the stop price, it will activate a marketable order. Notice that as the share price increases, the live stop price also increases. This will continue until the order is either cancelled or until the share price falls by the Trailing amount to activate the stop.
Now that we’ve covered the Trailing Stop, let’s take a look at the Trailing Stop Limit and how it differs.
Let’s repeat the order entry, but this time instead of the TRAIL order type, we’ll select TRAIL LIMIT.
To start, we’ll again select another long position from the Portfolio tab to populate the position in the Order Entry panel, select Sell, and then the number of shares we want to sell.
From the Order type dropdown menu, this time, as we mentioned, we’ll select Trail Limit.
This helps you add a layer of price protection so that your Stop order does not become a marketable order, should the stop trigger, and execute further away from the market than you expected.
In the case of the Trail Limit order, to define a limit price, I will need to enter both Stop and Limit.
The difference between the Stop and Limit price will be displayed as a Limit Offset on the Orders tab in the Activity monitor.
For example, an order with a Stop price of $49.25 and limit price of $49.00 would have a Limit Offset of 25 cents.
These two values move in lockstep – or trail the share price should it rise,but remain intact should it fall.
The purpose of the limit offset is to create a minimum value that the stop order will execute at once the stop is activated.
The stop is a function of the Trailing value.
Upon transmitting the order, the stop price is system calculated, subtracting the trail amount from the market price at the time of execution.
Should the share price fall by the amount of the trail, the stop is activated, but the execution is limited to the distance below the stop as determined by the limit offset. However, should the share price rise, the stop and limit prices will rise in tandem.
Note: While our examples have focused on selling long positions using the Trail and Trail Limit order types, you can also establish buy stops on short positions, which act in precisely the opposite way.
As there are a lot of moving parts to these order types, we urge you to refer to the study notes below this lesson for examples and try them on your own using a TWS paper account for simulated trading.
This concludes our Order Types course. For more information, remember to look at the entire library of courses at Traders’ Academy under the IBKR education menu. Thanks for joining us.
The analysis in this material is provided for information only and is not and should not be construed as an offer to sell or the solicitation of an offer to buy any security. To the extent that this material discusses general market activity, industry or sector trends or other broad-based economic or political conditions, it should not be construed as research or investment advice. To the extent that it includes references to specific securities, commodities, currencies, or other instruments, those references do not constitute a recommendation by IBKR to buy, sell or hold such investments. This material does not and is not intended to take into account the particular financial conditions, investment objectives or requirements of individual customers. Before acting on this material, you should consider whether it is suitable for your particular circumstances and, as necessary, seek professional advice.
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The order types available through Interactive Brokers LLC’s Trader Workstation are designed to help you limit your loss and/or lock in a profit. Market conditions and other factors may affect execution. In general, orders guarantee a fill or guarantee a price, but not both. In extreme market conditions, an order may either be executed at a different price than anticipated or may not be filled in the marketplace.