A trailing stop is an excellent method with which forex and CFD traders can either minimize their potential losses on a position, or secure potential earnings. It is a standing order that the trader gives his broker to close out his position when it hits a certain point above/below the stock price’s peak. While a trailing stop can be in a dollar amount, it is more commonly a percentage above/below the high/low of a stock price.
If a trader were to buy 50 shares of a company stock at $50 per share, he may place a trailing stop at 10%. That is to say, if the price drops 10% to $45, then his broker has a standing instruction to sell the shares, thus keeping the loss at a $5/share, or $250 total. However, if the stock price rises, the trailing stop of 10% rises with it, and if the price peaks at $80 before beginning to fall, then the trailing stop is $72, or 10% of the $80 peak that the price reached. If the price now falls below that 10% line, the broker has instructions to sell, thus enabling the trader to earn $22 per share, or $1,100, before the stock price continues to drop.
Successful traders are those who can find the proper balance to ensure that the trailing stop is not too large, thus risking higher losses, but at the same time, big enough to allow for the stock price to correct any anomalies and continue in the desired direction.