A trailing stop is a special type of trade order that moves relative to price fluctuations.
Trailing stops only move in one direction because they are designed to lock in profit or limit losses. If a 10% trailing stop loss is added to a long position, a sell trade will be issued if the price drops 10% from its peak price after purchase. The trailing stop only moves up once a new peak has been established. Once the trailing stop has moved up, it cannot move back down.
A trailing stop is more flexible than a fixed stop-loss order, as it automatically tracks the stock's price direction and does not have to be manually reset like the fixed stop-loss.
Investors can use trailing stops in any asset class, assuming the broker provides that order type for the market being traded. Trailing stops can be set as limit orders or market orders.
Trading with Trailing Stop Orders
The key to using a trailing stop successfully is to set it at a level that is neither too tight nor too wide. Placing a trailing stop loss that is too tight could mean the trailing stop is triggered by normal daily market movement, and thus the trade has no room to move in the trader's direction. A stop-loss that is too tight will usually result in a losing trade, albeit a small one. A trailing stop that is too large will not be triggered by normal market movements, but it does mean the trader is taking on the risk of unnecessarily large losses, or giving up more profit than they need to.
While trailing stops lock in profit and limit losses, establishing the ideal trailing stop distance is difficult. There is no ideal distance because markets and the way that stocks move are always changing. Despite this, trailing stops are effective tools. Every exit method has its pros and cons.