What Is a Trailing Stop and How Does It Work?

A trailing stop represents a dynamic type of stop-loss order designed to protect gains or limit losses on an investment. Unlike a traditional fixed stop-loss order, a trailing stop automatically adjusts as the market price of an asset moves favorably. This mechanism allows an investor to secure profits as the price increases while still providing protection against a significant downward reversal.

The core function of a trailing stop involves “trailing” the asset’s highest price by a predetermined amount or percentage. If the asset’s price rises, the trailing stop price also moves upward, maintaining the specified distance from the new peak. However, if the asset’s price declines, the trailing stop price remains fixed, preserving the last calculated stop level.

For a long position, an investor buys a stock at $50 and sets a $2 trailing stop, initially at $48. If the stock rises to $55, the stop adjusts to $53, maintaining the $2 difference. Should the stock drop to $52, the stop remains at $53, as it only moves with profit. If the stock falls to $53, the order triggers, converting to a market order to sell. This automatic adjustment helps investors participate in upward movements while setting a floor against pullbacks, and the order remains active until triggered or canceled.

Setting a Trailing Stop

Implementing a trailing stop involves specifying how the stop price will track the asset’s market value, typically through a brokerage platform’s order entry system. Investors generally have two primary methods for setting the “trail”: a fixed dollar amount or a percentage.

When using a fixed dollar amount, the investor specifies a precise monetary value below the asset’s highest price. For instance, if a stock is trading at $100 and an investor sets a trailing stop with a $3 fixed amount, the initial stop price is $97. If the stock then rises to $105, the stop price automatically adjusts to $102, always staying $3 below the new peak. This method provides a clear, absolute buffer regardless of the stock’s price level.

Alternatively, a trailing stop can be set as a percentage, which calculates the stop price based on a proportion of the asset’s current market value. For example, an investor might set a 5% trailing stop on a stock currently trading at $100. The initial stop price would be $95. If the stock price climbs to $110, the new stop price would be $104.50 (5% below $110). This percentage-based approach ensures the stop amount scales with the asset’s value.

The choice between a fixed dollar amount and a percentage often depends on the investor’s strategy, the asset’s volatility, and its price per share. Once set, the platform continuously monitors the asset’s price and adjusts the stop level accordingly.

Applying Trailing Stops

One common application is to protect accumulated profits on an existing winning trade. As an asset’s price increases, a trailing stop allows the investor to secure a portion of those gains, preventing a significant reversal from eroding all the unrealized profit. This provides a disciplined approach to locking in returns.

Additionally, trailing stops are used to limit potential losses on a new or existing position. By setting a stop a certain distance below the purchase price or a key support level, an investor can define their maximum acceptable loss. If the market moves unfavorably and hits this level, the order is triggered, helping to prevent further capital erosion.

When a trailing stop is triggered, it converts into a market order. This means the order will be executed at the next available market price, which may not be precisely the stop price, especially in fast-moving or illiquid markets.