One of the most used slogans in the financial markets is “cut your losses fast and let your profits run”. To achieve this goal you need tools to help you achieve this end. And what tool can I bring you to make your profits safe? In this article we will see what trailing stop is in Forex and how it works.
If you have never used it, or you have never heard of trailing stop, it is time to try it in your trading strategy. In short, this tool is a dynamic stop loss, that is, it moves in your favor when the price moves in your favor and slows down when it goes against it.
With a well placed trailing stop in a trade, you will be able to let your profits run and minimize your losses, as your stop loss will be constantly moving in your favor while the price moves in your favor. The moment the price changes direction your trailing stop will not move and will meet your stop loss.
HOW DOES DYNAMIC STOP WORK IN FOREX
To help you understand it better, look at this image. Where the black line would be the price and the red line would be the dynamic stop loss or trailing stop that will move automatically following the price:
The main function of the trailing stop is to set the exit level of a trade automatically by maintaining the margin you set. All this without you having to do it manually. It is a way to automate the stop loss, so you don’t have to constantly check your trades.
The trailing stop or dynamic stop loss, is often used for long-term strategies, as you must leave a certain margin of price fluctuation. As you know within a trend there are micro trends.
The best way to use trailing stop is by making long term investments, so that the stop loss is not too close to the price, and consequently you jump into a micro trend that goes against you.
The Forex market is open 24 hours a day, five days a week. The trailing stop is a perfect tool to avoid having to constantly monitor your trades and review your stop loss. You make your entry to the market, set the stop loss, and activate the trailing stop.
FOREX TRADING EXAMPLE
Now that you know what trailing stop is, imagine that you want to make a long term investment in the EUR/USD pair. You enter the market by buying EUR/USD, and your stop loss is set at, say, 50 pips against. Then, so you don’t have to check your stop loss every day when the price is in your favor, you can activate the dynamic stop loss or trailing stop option.
Your stop loss will automatically move to the 50 pips margin when the price moves in your direction. When the price goes against you, the stop loss will remain at its highest point. If the price drops more than 50 pips, your stop loss will be triggered and you will exit the trade.
But if on the contrary it is a simple reversal and the price continues to trend, your trailing stop will continue to do its job and will go up with the price, keeping those 50 Pips of margin.
Let’s see in this image how this tool works:
TIPS ABOUT TRAILING STOP
It’s a very good tool but you have to understand what trailing stop is and how it works in order to get the most out of it. As I told you before, you have to be careful with the stop loss margin you use.
The main mistake when using this tool is to put it too close to the price. So, as soon as there is a micro trend against it it takes you out of the trade.
During a long term trend, the price evolves in a zigzag pattern. If you want to get into that macro trend, keep in mind that there will be times when the price evolves against you, so there has to be a certain distance between the price and the stop loss.
Stop losses, like trailing stops, are designed to protect your capital, but keep in mind that if you put them too close to the price, you will skip stop and soon after see how the price follows the trend you anticipated.
I recommend that before setting your dynamic stop you analyze the currency pair you want to trade, and calculate the zigzag ranges in which it usually moves in the micro trends, so you do not fall short.
This tool works best for long term investments in currency pairs that are in trend. Use four-hour or daily charts to look for macro trends and set the dynamic stop loss.