By Warren Seah - A trailing stop loss order will trail and automatically close a trade at a set level in order to prevent further losses. If a buy (long) order has been placed, then the stop-loss level is set at a price that is lower than the buying price. On the other hand, if a sell (short) order was triggered, then the stop will be placed above the selling price.
A general rule is that the exit strategy must coordinate with a trader’s entries and his overall trading system. For trending system, it is required that the trader set a bigger stop loss level which allows more room for the trade to breathe. If it is a contrarian system or breakout system, a small stop loss should be set so that trade will exit immediately if it is a bad trade. Thereby, traders’ loss will be limited in such forex trading system.
There are a variety of stops that one can incorporate into a system.
1. Initial Stop This is the first stop set at the beginning of the trade. This stop is identified prior to entering the market. It is used to calculate the position size of the position at which to trade and this is also the largest loss a trader will take in the current trade.
2. Trailing Stop Develops as the market moves. This stop enables the trader to lock in profit as the market moves in the favor. Trailing stop ensures that the stop loss follows the price movements closely as the trend develops. This is to prevent any sudden market movements from taking out profits should the trend starts to reverse.
3. Two Bar Trailing Stop This is used in a trend if the market seems to be losing momentum and a reversal is anticipated.
4. Moving Average Trailing Stop Moving average indicator is most common used for trailing stop loss.
5. Average True Range Trailing Stop Also called ATR indicator. This indicator is mostly used by turtle traders or trend following traders to determine market volatility and place their stop loss away from volatitily and protecting their profits at the same time.
6. Parabolic SAR Trailing Stop Another indicator widely used for placing your stop loss.
6. Channel Trailing Stop Also a commonly used trailing stop technique for turtle traders or trend following traders.
Is Your Stop Loss Selection Based on Market Dynamics?
It means that have you taken in to account market conditions that will tell you how much room you need to give the trade to breathe so that your trade will not be exited due to market noises and repeatedly stop out? There is no perfect stop loss strategy but the most ideal stop loss strategy has to be discovered and worked out by the trader via back testing and forward testing.
About the Author
By Sean Hyman, Currency Analyst
Let me go on record right now as saying a trailing stop is one of the most MISUSED orders out there in Forex.
At first glance, it appears that if you put in an order and a stop with a trailing stop, then it seems like you’re guaranteed to capture a profit. However, this is not always the case.
A trailing-stop is the order you use when you are “right” on a particular trade.
A trailing stop does NOT replace a regular stop-loss. In fact, you use a trailing-stop in addition to your regular stop-loss. It’s really two separate instructions for the exact same trade.
When you place a trade, you always add a stop-loss. Then your trading software will automatically close out your trade if the price reaches your desired stop-loss.
However, the trailing stop tells the exact same stop-loss to move forward by a certain amount.
Here’s where people get confused: They think ANY advancement is a profit for them. However, they are thinking about the pair moving and not where their stop is moving from. In reality, your pair still has to move a certain amount for you to make a profit, whether your stop-loss is moving.
Here’s an example: Remember, earlier we were buying USD/JPY at 98.00 with a stop at 97.00. If we add in a 30 pip trail to that, each time the pair moves 30 pips from where we entered the trade, then the stop-loss ALSO advances by 30 pips.
So if the pair moves from 98.00 to 98.30, then our stop-loss moves from 97.00 to 97.30. Yes, our stop moved, but you will notice that it doesn’t mean we are profitable on the trade. In fact, we are still 70 pips away from breakeven. Our trail-stop has to “hop” in 30 pip increments three times for us to profit.
Two Correct Ways to Use a Trailing Stop
How do you solve this problem so your trail stop guarantees you lock in profits? There are a couple of ways.
1. Place a trail stop that is wider than the distance between your entry and stop level. Example: Buy USD/JPY at 98.00 with a 50 pip stop at 97.50. Now I also add in a trail stop order for 60 pips. Since my trail stop is wider than the distance of my regular stop, if it moves up, it ensures at least some profit. In this example, once the USD/JPY pair moves from 98 where I got in, to 98.60, the trail stop kicks in and “hops” instantly up 60 pips from 97.50 up to 98.10. Therefore, I’m for sure 10 pips in the profit in this example.
2. Only use a trail stop once your trade has moved enough that you’re at break even, even if your stop-loss is triggered. Once you’re at breakeven, any trail-stop will lock-in profits. Example: So if I took that same USD/JPY trade and when the pair moved from 98.00 to 99.00, I manually moved my stop up to breakeven at 98.00. Then I can add in a trail stop of ANY size, then it will surely lock in profits IF the pair continues upward by the amount of the increment we chose.
Now Here's WHEN You Should Use the Trailing Stop!
So when should you be using these anyway? Because it’s not a good idea to use them all the time. (However, a regular stop should be used on EVERY order to protect your trading account.)
Here’s the answer. Trail stops are BEST used when a strong momentum type of move is happening. It’s when you see the price going so strong that the angle of the trend slope is very steep. This is where the trail stop is best used.
Why? It is most likely to kick in the trail and move up. It also shows a strong trend. If you’re in a strong trend, you want to soak as much as you can out of it. Thus you don’t want to “cap” your gains with a limit order, so you place a trail stop instead.
When do you NOT want to use a trail stop? You don’t want to use a trail stop when the pair is in a sideways range (no trend) or when it’s in a very mild trend. Think “trailing stops” when you see huge, momentum (fast, steep) moves in the pair.
In other words, you use a trail-stop when you are in a pair and the profits are coming very quickly in a short span of time.
If the pair is in a sideways range, then just put in a regular stop and a limit where the pair comes to the other side of the range.
Also, some pairs tend to be quicker movers than others. For instance, GBP/JPY is known to be a quick mover much of the time. It can clear hundreds of pips each day in a small span of time.
So a “fast moving” pair is ideal for trail stops. However, a “tame” pair like CHF/JPY typically wouldn’t normally be a great pair to use a trail stop with because its moves are not that quick and fast typically. However, if it ever were to fit that criterion, then by all means, you can implore the trailing stop.
So I hope this helps to clear things up.
One final note: Practice using your first couple of trailing stops on your broker’s demo account. That way you aren’t risking hard earned dollars while you make sure you are getting the order in right.
Brought to you by Alans Forex Blog:
Forex exit strategies are a very important part of forex trading systems.
In fact, it could be said, that out of all the components of a trading system, it's the exit strategy and the money management rules of a system that are the most important to help make a system profitable and have an acceptable drawdown.
Let's firstly get an overall picture of what are the variosu types of exit strategies that are used together in a forex system. And then we'll go through a real life trade to show you these strategies in action! This is the best way to learn about how they work and why they're there.
So firstly, realise that there are 5 important forex exit strategies:
1. When you’re in a position, you usually have an initial stop, which may or may not be the same as your trailing stop, depending on the system that you’re trading. The purpose of the initial stop is to get you out of the trade, if the trade goes against the direction of the trade early on in the trade. It therefore serves to limit your losses. The initial stop is usually closer to the entry price than the trailing stop, and thus is the one used, until the trailing stop comes through it.
2. A breakeven stop may also be used. This is where your trailing stop loss is moved to the breakeven point (the price where if you exit, will be equal to your entry price). This stop, if present, serves to protect profits. This is especially true during volatile markets where currency prices may fluctuate enough to get you out too frequently at your trailing stop, if a breakeven stop is not used.
3. You may also have a take profit stop. This is when you exit the full position or half the position, when a target profit of “x” number of pips, or some other criteria if the trading system has been reached. Many systems use a take profits stop as they're more profitable with a take profit stop as well as a trailing stop, instead of just having a trailing stop. This would have been determined during backtesting or forward testing of the system.
4. The trailing stop, as a part of your forex exit strategy, is a stop that moves in the direction of the trade, which is up for a long trade and down for a short trade. An ideal stop is one that allows enough "room to move" and hence allows the profits to run, and of course eventually gets you out when the trade does turn against you.
5. Finally, a trade may be exited before a major economic announcement, because during such an announcement, there may be a temporary but very large increase in volatility that may cause you to be stopped out at your trailing stop.
So really, there are 5 common types of stops in all: initial, trailing, breakeven, take profit stops, and stops due to fundamental events in the market such as announcements
Lets have a look at these stops in more detail.
We'll do this by having a look at real life trade on the GBPUSD.
A short entry was signalled at 1.7640 (point "a”), and the initial stop loss was 1.7658 (point “b”):
In this system, the initial stop loss is the same as the trailing stop loss, and is determined by peaks and troughs. In a short trade, as it is in this example, the trailing stop is placed a certain number of pips above the occurrence of a peak, as we have seen at point “b”.
Note that the way you’d work out when a peak or trough has occurred will depend on your system. For this example, just know for now that the price action defined a peak at the high of the candle marked point “b”.
In this system, as mentioned the trailing stop is used as the initial stop. But let’s say for a moment that we did have an initial stop at say 1.7648, which is lower than the trailing stop. If this was the case, then the initial stop applies, and the trailing stop is irrelevant at this point in time, as the initial stop will be hit first if the price rises. In fact, the trailing stop would be irrelevant until it is lower than the initial stop.
So what happens as the trade progresses?
Firstly note that as new troughs are formed, that trailing stops are typically never moved backwards. That is, for this short position, they’re moved down as lower peaks are formed, but not back up if higher peaks are formed. You’ll see this soon.
Next, if your system has a breakeven stop, then when the currency reaches the breakeven price, your trailing stop is moved to this price. Then from this point onwards, your trailing stop would stay here until lower peaks are formed below this breakeven price, causing the trailing stop to be moved lower once more. There’s no breakeven stop in this system.
Now, what does happen in this trade, is that the profit target of 30 pips is reached, and according to the systems rules, half of the total position is closed at the chart price of 1.7605, at point “c”:
The half position is actually transacted at 1.7610 (1.7605 plus spread) as it is a buy order, hence the 30 pips profit on half the position (1.7640 - 1.7410 = 30 pips).
Now, after you’ve done this, you’d only have half of the face value remaining, so you’d simply have to then adjust your stop loss to cover half of the original face value, instead of the full original face value.
A variation of this, is that instead of exiting half at that point, you’d have a trailing stop for half your position at that profit target price, and a trailing stop for the other half at where the trailing stop normally is.
The trade continues, and the trailing stop is adjusted down to point “d” and then beyond to "e", "f" and "g"...
Remember the trailing stop is not moved back up (in a short position), because this means that the trailing stop is going in the wrong direction.
Finally, as the price action reverses and breaks through your trailing stop at point "i", you’re exited from the position at the " exit candle":
This trade in fact made 30 pips on the first half, and 90 pips on the second half. Not bad at all, especially since it only took only 2½ hours.
So there you have it, you’ve just learnt the intricacies of the various types of forex stops in a forex trade :)
If you’re new to forex, these may be new concepts for you. But if you grasped the above, then you have grasped some valuable concepts and skills in forex trading. It will also help you to learn new forex systems a lot faster.