Mastering the Art of Trailing Stop Losses: Balancing Risk and Reward
Trailing stop losses are an essential risk management tool for day traders. However, it’s an important skill to practice as trailing stops that are set too aggressively can often result in your trade being stopped out prematurely,
just before the price moves in your expected direction.
In this post, we’ll dive into how to trail stop losses effectively, sharing different strategies that provide a balance between protecting profits and giving the trade enough room to breathe.
Why Use Trailing Stop Losses?
A trailing stop loss allows you to lock in profits as the market moves in your favor while ensuring that you are not exposed to unlimited losses if the trade reverses.
This is especially important in volatile markets, where prices can fluctuate significantly in short periods.
However, the key to successful trailing is finding a balance—setting it too tight will cause premature exits, and too loose can result in giving back a substantial portion of your profits.
Strategy 1: Fixed Percentage Trailing Stop
One of the simplest methods is using a fixed percentage trailing stop. This approach moves the stop by a pre-set percentage as the price moves in your favor.
Example: If you enter a trade at $100 and set a 2% trailing stop, your stop would initially be at $98. If the price rises to $105, your stop adjusts to $102.90 (2% below $105).
If the price drops to $102, you exit the trade.
This method works well for less volatile assets where price swings are generally within predictable ranges.
However, in highly volatile markets, you may be stopped out quickly before a trade has a chance to reach its full potential.
Pros:
- Simple to implement.
- Automatically adjusts to price movements.
Cons:
- Doesn’t account for market volatility, which can lead to premature stops.
.
.
Strategy 2: ATR-Based Trailing Stop (Volatility Adjusted)
A more dynamic approach is to use the Average True Range (ATR) to adjust your stop based on the asset’s volatility.
ATR measures the average price range of an asset over a given period, and by using it, you can ensure that your stop-loss adapts to market conditions.
Example: Let’s say the ATR of an asset is 1.5 points. You might decide to set your trailing stop at 2x ATR. If the current price is $50, your initial stop would be placed at $47 (2 x 1.5).
As the price rises, your stop would trail at 2x ATR from the new price level.
This method allows the stop loss to follow the market without being too tight in volatile periods or too loose when the market is calm.
Pros:
- Adapts to market conditions.
- Provides more room during volatile periods, reducing the risk of being stopped out too early.
Cons:
- Requires monitoring and adjustment based on volatility.
Strategy 3: Swing High/Low Trailing Stop
This strategy involves placing your stop at the previous swing low in an uptrend (or swing high in a downtrend).
This allows your stop to move along with the trend while giving the trade enough breathing room.
You decide which time frame to use to identify the previous swing low, but I would suggest using the 4 hour chart if you are a subscriber following my daily technical analysis & trade ideas.
Example: In an uptrend, as the price makes higher highs and higher lows, you place your stop below the most recent low.
Each time the market makes a new high and retraces, you move your stop to just below that new low.
This method works well in trending markets, ensuring that you stay in the trade as long as the trend continues.
Pros:
- Very effective in trending markets.
- Helps avoid being stopped out by market noise.
Cons:
- Requires manual adjustment.
- Doesn’t work well in sideways or choppy markets.
.
.
.
Strategy 4: Moving Average Trailing Stop
In this strategy, you trail your stop loss using a moving average, such as the 50-period EMA (Exponential Moving Average).
As the market price moves, the EMA moves along with it, providing dynamic levels of support or resistance.
If you are a subscriber following my daily technical analysis & trade ideas I would suggest using the 1 hour chart in a steep trend or the 4 hour chart if there is a trend with quite deep pullbacks.
Example: If you enter a long trade, your stop is placed just below the 50-period EMA. As the price rises, so does the EMA, and you adjust your stop accordingly.
If the price crosses and closes below the EMA, you exit the trade.
This method is excellent for capturing long trends while avoiding getting stopped out too early in pullbacks.
Pros:
- Ideal for riding longer trends.
- Automatically adjusts with price movements.
Cons:
- Not suitable for very short-term trades.
- Can be lagging, resulting in giving back more profits.
Strategy 5: Fibonacci Retracement Trailing Stop
For traders familiar with Fibonacci retracement levels, these can be a powerful tool to trail stop losses.
This is the trailing stop strategy I tend to use.
Once a significant price move has occurred, you can trail your stop using Fibonacci levels, such as the 38.2% or 50% retracement level.
Example: Suppose you enter a trade, and the price moves favorably. You can trail your stop using the 38.2% retracement level of the most recent leg up.
This strategy works well when the price is in a clear wave pattern, often seen in trending markets.
Pros:
- Strong alignment with market psychology and natural price levels.
- Provides logical levels for trailing stops.
Cons:
- Requires familiarity with Fibonacci levels and proper market structure.
Finding the Balance: When Not to Trail Too Aggressively
Trailing stops can often take you out of a trade just before a significant move. This usually happens when the stop is set too tight in a volatile market.
It’s crucial to allow your trade room to breathe—particularly if you’ve identified a strong trend.
Here are a few tips to avoid trailing too aggressively:
- Assess Market Volatility: Use ATR or Bollinger Bands to gauge volatility and avoid placing stops too close in choppy markets.
- Give Room in Trending Markets: If the market is in a strong trend, consider using a wider trailing stop, such as 2-3x the ATR or a trailing stop based on a moving average.
- Use a Hybrid Approach: You don’t have to stick to one method. For example, you might start with a percentage-based stop and then switch to an ATR stop once the trade is moving in your favor.
