Before comprehending trailing stops first of all you should remind yourself that foreign exchange trading is done through issue of instructions, called orders, by a customer to a broker to buy or sell a currency pair at certain price. The order remains valid until executed or cancelled by the customer. Various types of orders are widely used – a market order (executed immediately at current market price), limit order (an order with restrictions on the maximum price to be paid or the minimum price to be received) and many other kinds of conditional orders. Trailing stop loss orders are limits set in order to close loss making positions at certain price levels and to avoid excessive losses. Scale of the limits depends on a trader’s daily open position volume and constrains maximum loss value from the closure of the position under unfavorable price fluctuations. In other words forex trailing stop loss orders are used to minimize losses when a price movement goes against a trader’s strategy.
When price quotations on a forex trader’s open positions move favorably stop loss level should be manually shifted upwards to fix earned profit. A tool that makes this shifting automatically is called trailing stop. It’s one of the most efficient profit maximization instruments in the forex trading market.
Trailing stop is a stop loss order set at a percentage level to the market price thus a stop parameter is adjusted as the price fluctuates, always maintaining the same percentage below (or above) the market price. It works well when the price moves in strong trend and allows profits grow while cutting losses at the same time. In some sense the trader is guaranteed that his or her potential losses will not exceed the predetermined level while profits still remain unlimited.
Technically trailing stop is maintained as an instruction in customer’s trading platform and only relative stop loss orders are transmitted to the broker’s server. When a stop parameter is set a trading software program check current quotations, calculates stop level and place stop loss order. If the price floats favorably then the system readjust stop loss order automatically. If the price progress breaks unfavorably no changes in orders are made and when it reach stop limit the order is executed. As a result open position’s profit is fixed without human intervention. All trailing stop movements are recorded in a system log.
This system makes short term trading especially convenient. Traders, willing to profit from daily price fluctuations, may leave their working place without risk that change in trend direction will nullify returns or cause losses. Meanwhile trader’s terminal should be kept active and on line; if it is turned off trailing stop will not function. Only the last issued stop loss order will remain valid with the broker.
Each opened position may have only one trailing stop. Designation of stop parameter value (and acceptable losses accordingly) is perhaps the most difficult aspect of establishing a trailing-stop system.
Trailing stop is very useful on trendy market but become less efficient when the market is flat. Small controversial price fluctuations in this case constantly interrupt stop loss mechanism work. Except of direct price trailing, the system may also work with certain financial indicators – Moving Averages, Ichimoku indicator or specifically designed The Parabolic Stop and Reverse (SAR) – in order to neutralize short term fluctuations influence.
It’s highly recommended for beginner forex traders to use trailing stop together with stop loss and take profit orders for management of open positions and effective trade control.