What is a Trailing Stop?
A trailing stop is a modified stop-loss order that automatically adjusts upward as the price of a security rises, but stays fixed when the price falls. It is set at a fixed percentage or dollar amount below the market price. For instance, a 10% trailing stop on a stock purchased at $100 initially triggers at $90. If the stock rises to $130, the stop moves up to $117, locking in at least a 17% gain.
Choosing the Right Trail Distance
The trail distance should reflect the stock's typical volatility. A stock with average daily swings of 3% needs a wider trail than one that moves 1% per day. Using the Average True Range (ATR) indicator is a data-driven approach: setting the trail at 2x the 14-day ATR accommodates normal price fluctuations while still protecting against genuine reversals. For a stock with a $2 ATR, that means a $4 trailing distance.
Key Considerations
Trailing stops work best in trending markets. In choppy, sideways markets, they tend to trigger prematurely during routine pullbacks, forcing you out of positions that subsequently recover. Consider widening the trail distance during periods of elevated volatility, or temporarily switching to fixed stop-loss levels when the market lacks a clear directional trend.