“Alright, stop! Collaborate and listen.”
The concept of managing losses, ensuring they don’t get out of hand, is constantly drummed in the minds of forex traders. Of course, we generally use a stop loss to achieve this goal. However, once you have excelled at this stage, it’s time to look at ways of maximising your profit equity.
This is where forex trailing stops come in. Instead of manually locking profits in a live position, a trailing stop strategy does this for you. But should you use a trailing stop in forex? What are the benefits and drawbacks of this approach?
Whats a trailing stop in forex?
Before exploring the trailing stops meaning, we need to uncover what a traditional stop loss is. A stop loss or stop is a type of order designed to automatically close a position for a loss at a specified price.
It’s the primary tool to keep losses manageable, preventing them from getting out of control and a potential margin call. A trading ‘commandment’ is that you never fiddle with your stop during a trade’s initial stages.
Yet, you certainly have the liberty to do so after some time when your position shows a floating profit. This is where many traders use the trailing stop in forex. It is a modified stop designed to lock in gains at a pre-planned number of points as the price moves in your favour.
The trader decides beforehand the number of pips the trail stop will travel based on a list of default or custom options provided by their trading software.
The trailing stop in forex will remain fixed at a certain level until the market travels oppositely, closing your entire position for a profit. It’s worth noting that the trailing stop only progresses in one direction and doesn’t go back the other way.
As you can see, a trailing stop is a ‘dynamic’ type of stop loss. Without it, you can manually move the stop at your own predetermined points as the price moves favorably. However, trailing stops automate this process, which is beneficial, especially when you are not present watching the charts.
You can apply a trailing stop in forex before or during a position like a conventional stop.
How does trailing stop work (trailing stop example)
Now, we’ll dive deeper into the trailing stop meaning by looking at how it works in practical terms. Let’s look at the chart below.
Imagine that you went short at 1.92383 with a 20-pip stop at 1.92583. Furthermore, you decide to trail your stop at a 20-pip distance. When the price moved from 1.92383 to 1.91383, your stop would have moved to 1.92383.
Afterwards, your trailing stop would have moved at every 20-pip increment from the last point it was located. Note this movement on the chart above.
At 1.91183, with your stop now at 1.91383, the price retraced above 20 pips, effectively exiting you out of the market. You would have secured 100 pips for this position (from 1.92583 to 1.91383.
It goes without saying this is a flawless demonstration of the trailing stop in forex. Things are not always so rosy (more on this later).
Note: the distance of the trailing stop cannot be lower than the spread at any set time. So, if the spread is 5 pips, for instance, your trail stop must be above this amount.
Benefits of the trailing stop in forex
Automatic securing of profit
Unless you are a scalper or day trader, it’s not always possible to be near your charts constantly, especially with a full-time job. So, what happens when your position goes into profit, and you haven’t placed a trailing stop in forex?
There are some situations when the market can quickly reverse against your order, turning what previously was a profit into a loss. Trailing stops can be highly advantageous in these situations because they can secure your gains without manual intervention.
The second benefit of having a trailing stop strategy is that it saves time. We had mentioned that you don’t need to be in front of your screen with this tool.
Additionally, trailing stops make it easier to maintain your stop losses in multiple positions simultaneously. Without this feature, it would take time to micro-manage each order one by one.
Although the difference may only be a few tens of seconds, it does help in highly volatile markets, provided you keep your emotions or psychology in check. The benefit of automatic micro-managing hits home with short-term traders and far less with long-term chartists like swing traders and position traders.
Drawbacks of the trailing stop in forex
The main disadvantage of forex trailing stops is that they often prevent you from reaping the maximum from a position. This is especially true when you set them too close to the price. Trailing stops aren’t the best way of truly ‘letting your profits run’ because the price hardly moves in a straight line.
Therefore, your position is always at risk of being closed prematurely due to natural (and sometimes erratic) retracements. Some traders need to understand the trading conditions and how they affect their management of positions.
The trailing stop in forex works poorly in volatile and range-bound markets. Conversely, it tends to fare better when the price is fast-moving or in a parabolic-like state with tiny corrections. The last example is a perfect demonstration, but breakouts and high-impact news events also count.
Let’s look at an example on the EUR/GBP 4HR chart to demonstrate the disadvantage of forex trailing stops.
=Here, the pair was in a bigger range between the 0.85460 and 0.88670 levels. But we’d like to pay attention to the highlighted section, where the price bounced in a 100-pip range before finally taking off.
If your trailing stop were set at, say, 20 pips after entry near 0.85460, you would have been kicked out of a trade which later travelled a considerable distance.
So, in such situations, you may need a different trailing stop strategy or not use one at all.
If you decide to use a trailing stop in forex, remember to set a reasonable distance which allows your position enough ‘breathing room.’ This can prevent premature stop-outs. How you arrive at this decision depends on your trading style.
The alternative, of course, is to stick with a traditional stop loss and move it yourself. This offers more flexibility because you can choose the right placement based on your discretion.
Unlike other tools, much ambiguity exists with trailing stops, especially when choosing the most optimal incremental distance for the order.
Some traders use indicators like moving averages, tools like Fibonacci, support/resistance and various chart patterns to guide their decisions. Others prefer a simpler approach using the natural swing highs/lows of price as reference points for their trail stops.
Like any technique in forex, it boils down to trial and error when deciding on the most successful trailing stop strategy.