Using a trailing stop loss is a great way to lock in profits or limit risk in an active market. In fact, professional futures traders frequently implement these strategies to optimize their capital efficiency in real time.
Trailing Stops: The Best of Both Worlds
A trailing stop loss is a dynamic order placed on the market that moves in concert with evolving price action. It features reactive functionality, meaning that the order’s exact location depends on the behavior of price itself. Therein lies the beauty of a trailing stop: It limits risk while preserving a chance of extraordinary rewards.
Trailing stops come in all shapes and sizes and are a popular way of managing open positions in the live market. A few of the most common are static (finite number of ticks), breakeven (stop loss moves to original entry), and time-based (stop location defined according to the minute, hour, or session).
Trailing stops offer the utmost flexibility; no matter what your trade management objective may be, there’s a trailing stop strategy well suited for the job. Let’s take a look at one instance when a trailing stop loss order can lead to big profits: trading breakouts.
Trading Breakouts with the Trailing Stop Loss
A breakout is a sudden directional move in asset pricing. Market breakouts occur for a multitude of reasons, both technical and fundamental. Active futures traders often target breakout-friendly products—such as commodity, equities index, or agricultural contracts—to pursue potentially large rewards.
Trailing stops are ideal for breakout trading because they incrementally reduce risk as a market moves directionally. To illustrate, assume that Oliver is scoping out a bullish break over $65.00 in May WTI crude oil. At the traditional pit open (9 a.m. ET), Oliver executes the following trailing stop strategy:
- Oliver places a buy order for one lot of May WTI at $65.01.
- He chooses to implement a static trailing stop 25 ticks from entry with a 1:3 risk versus reward ratio
- When price hits $65.01, a stop market order is automatically placed at $64.76; a profit target (sell limit) is located at $65.76.
- As price rises, the stop market order also rises. For every positive tick above $65.01, Oliver’s trailing stop moves up by one tick.
Breakout trading is a great time to use a trailing stop loss strategy. As you can see, Oliver is attempting to cash in on swift, bullish price action above $65.00. If completely wrong, the realized loss is 25 ticks; if only marginally correct, Oliver’s liability is reduced; if correct, a 3:1 payoff is realized ($750.00).
Of course, any given trade may unfold in countless ways. Because of the unpredictability of price action, many professionals choose to couple an exceedingly large profit target with a much smaller trailing stop. This strategy is commonly referred to as putting on a “runner.” Let’s say that Oliver believes May WTI has the potential to move several dollars above $65.00. Oliver may decide that a runner above $65.00 is a worthwhile strategy:
- Oliver places a buy order for one lot of May WTI at $65.01.
- He uses a static trailing stop of 50 ticks with a 1:5 risk versus reward ratio.
- Price hits $65.01. A sell stop market order is placed at $64.51, and a sell limit order is placed at $67.51.
If WTI breaks out to the bull over $65.01, Oliver begins to limit risk while preserving a chance at large rewards. Although the odds of price immediately rallying to $67.51 are slim, check out how the trailing stop loss quickly turns risk and reward to Oliver’s favor:
| Positive Move (Ticks) | Assumed Risk (Ticks) | Risk vs. Reward |
|---|---|---|
| 0 | 50 | 1 to 5 |
| 10 | 40 | 1 to 6.25 |
| 20 | 30 | 1 to 8.33 |
| 30 | 20 | 1 to 12.5 |
| 40 | 10 | 1 to 25 |
Are You Ready to Use Trailing Stops in Your Trading?
It is important to remember that many factors can influence how any individual trade develops. And, although “catching a runner” using a trailing stop loss appears attractive, it takes a strong foundation to have the mentality needed to execute such a strategy correctly.
For insights on how to build a bullet-proof trading psychology, check out Daniels Trading’s online webinar “5 Concrete Tips to Build Your Solid Trading Foundation.” In it, you’ll learn how to hone your instincts and become an unflappable, disciplined trader.
