Managing risk with the trailing stop

January 20, 2018

Good traders always use a stoploss when they open a new trade. You can use a regular stop, but you can also use a trailing stop.

The forex market is characterized by a daily volatility which is higher than all the other financial markets (except for the new crypto currency market). Even a fluctuation of a few pips can cause important losses or profits due to the high leverage.

Setting up proper money management rules will help to avoid difficult situations and will allow you to maintain a reserve capital.

Among the methods used to place stop losses on a trade, the most famous one is obviously the regular and fixed stop loss. In this case the trade will be closed if the price falls below a certain level (or a certain percentage). The stop loss can also be modified at a later time, usually towards the entry point.

However, there is an alternative method of loss control called a trailing stop. This stop will automatically change the stop level when the exchange rate moves in our favour. So this kind of stop will follow the market prices and by doing so it will limit our losses or even protect our gains.

The basic concept of the trailing stop is that it takes into account the last top (low) reached by the exchange rate by moving the stop to maintain an adequate maximum distance from the same level.

The trailing stop is therefore dynamic and it is suitable for those trend following strategies that aim to follow the trend of a market while managing the risk correctly and gradually increasing the stop.

Let's now take a concrete example to understand how the trailing stop in forex works. Let's assume you have opened a long position on EurUsd at 1.2000 with a trailing stop at 1.1960 (a distance of 40 pips); if EurUsd rises up to 1.2040 (so 40 pips), the stop will adjust accordingly going up to 1.2000.

If the market moves against your trade then the stop will be activated automatically, setting a maximum loss already defined at the beginning.

The advantage of this type of operation is evident in a very volatile market such as the forex market. Through the trailing stop you can enter a trade and know that any market situation will occur from that point forward and will not result in losses greater than those expected with the stop loss. The trader will no longer have to worry about manually adjusting the stop loss, but it will be the platform to adapt the stop to the changing of market situations.

Another great advantage of the trailing stop is to remove the emotional component from trading. Very often the trader who constantly follows price dynamics observes the price movement with nervousness, and his emotions prevail. The early closure of the position is a mistake that many new traders make, while the correct rule is to cut losses, but let profits run as much as possible.

The trailing stop is an ideal risk management tool because it achieves this dual objective.

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