Online forex brokers offer various types of orders designed to protect investors from significant losses. In theory trailing stops provide a way for traders to limit losses and to lock in profits on individual trades. The basic idea of the trailing stop is that as a trade moves into profit, the stop level adjusts upwards in the case of a long (buy) trade or downwards in the case of a short trade. In this way the downside is limited by the stop level but the upside is potentially unlimited. In other words trailing stops are a way to allow profits to run and losses to be limited.
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.
A trailing stop allows a trade to continue to gain in value when the market price moves in a favorable direction, but automatically closes the trade if the market price suddenly moves in an unfavorable direction by a specified distance. When the market price moves in a favorable direction (up for long positions, down for short positions), the trigger price follows the market price by the specified stop distance. If the market price moves in an unfavorable direction, the trigger price stays stationary and the distance between this price and the market price becomes smaller. If the market price continues to move in an unfavorable direction until it reaches the trigger price, an order is triggered to close the trade.
Here is an example, let's say that you want to go long on EUR/USD, and you set an emergency stop that will be triggered if the market ultimately moves against you. After a day or so, the trade is completely in your favor, so you want to lock in some profit and see what happens. You could set a stop in positive profit territory, and make it a trailing stop. If the market continues to move in your favor, your profit lock will increase. That will continue to happen until the market flips back in the other direction and hits your stop. The primary function of the trailing stop is to increase your profit lock as the market moves, without the need for you to intervene and adjust.
In conclusion, trailing stops are a great trading tool that allows you to not only protect yourself but to lock in more and more profit, without watching the market every second. One of the tricks to using trailing stops is choosing the appropriate level. If forex traders choose a cushion that’s too big, they’ll face greater losses. A trailing stop that’s too tight, on the other hand, may trigger a sale before the stock has a chance to correct itself.