A trailing stop is a type of stop-loss order that automatically adjusts its price as the market price of an asset moves in a favorable direction. Unlike a fixed stop-loss, which is set at a specific price, a trailing stop is set at a percentage or a fixed amount below the market price (for a long position) or above the market price (for a short position). This allows traders to protect profits while still giving the trade room to run if the market continues to move favorably.
When the market price increases (for a long position), the trailing stop price also increases, maintaining the specified distance from the new market high. If the market price then declines and hits the trailing stop price, the trade is automatically closed. For a short position, the trailing stop would decrease as the market price decreases, and the trade would close if the price rises to the trailing stop.
Let's say you buy shares of Company X at $100 per share and set a trailing stop of 10%.
Initial Setup: Your initial trailing stop price would be $90 ($100 - 10% of $100).
Price Increases: If the price of Company X rises to $110, your trailing stop automatically adjusts to $99 ($110 - 10% of $110).
Further Increase: If the price continues to rise to $120, your trailing stop moves up to $108 ($120 - 10% of $120).
Price Decline: Now, if the price of Company X starts to fall from $120 and drops to $108, your trailing stop order will be triggered, and your shares will be sold at $108, locking in a profit.
If you had used a fixed stop-loss at $90, you would have missed out on the additional profit generated by the price increase to $120. The trailing stop allowed you to secure more of your gains while still providing protection against a significant reversal.