Trailing Stop Order

Trailing Stop Order is a Stop Order that continually adjusts the Stop Price as the market price of the security moves (i.e. trailing the security’s market price).
The Trailing Stop Price is placed at a set distance (either as an absolute dollar or as a percentage of the market price) below or above the market price, depending on whether it’s on a long or short position.
The Trailing Stop Price will then adjust as the market price of the security moves, maintaining the set distance.

If the market price hits or passes through the Stop Price, the order would convert into a Market Order, and will be filled at the best available price in the market at that time.
The same advantage & disadvantage of Market Order apply to Trailing Stop Order as well.

The advantage of Trailing Stop Order is that it can allow traders/investors to let the profits run (as long as the price does not fall to the Stop Price), while at the same time, limit the losses without continually having to adjust and place new Stop Loss orders.

Depending on the position on the market you have (long or short), there are 2 types of Trailing Stop Order:
a) Sell Trailing Stop Order (Trailing Stop to Sell)
This is the trailing stop order when you have a long position on a security.
In this case, the Trailing Stop Price is placed at a set distance (either as an absolute dollar or as a percentage of the market price) below current market price of the security.

The Stop Price will then rise as the market price increases (i.e. The Stop Price will be trailing the increasing market price from below: Stop Price = Increasing Market Price – Trailing Amount).
However, the Stop Price will remain the same (will not go lower) when the market price decreases.
Once the market price hits or passes through Stop Price, the order would convert into a Market Order to sell the security at the best available price in the market at that time.

b) Buy Trailing Stop Order (Trailing Stop to Buy)
This is the trailing stop order when you have a short position on a security.
In this case, the Trailing Stop Price is placed at a set distance (either as an absolute dollar or as a percentage of the market price) above current market price of the security.

The Stop Price will then move lower as the market price decreases (i.e. The Stop Price will be trailing the decreasing market price from above: Stop Price = Decreasing Market Price + Trailing Amount).
However, the Stop Price will remain the same (will not go higher) when the market price increases.
Once the market price hits or passes through Stop Price, the order would convert into a Market Order to buy the security at the best available price in the market at that time.

Note:
When placing Trailing Stop Order for an Option, the order will be triggered based on the market price of the option, NOT the market price of the underlying stock. Therefore, the Stop Price should be set based on the option’s price as well.

Therefore, just remember how the price of Call and Put options are related to the underlying stock price:
For a Call option, the option’s price increases when the underlying stock’s price increases, and decreases when the underlying stock’s price decreases (positive relationship).
On the other hand, for a Put option, the option’s price increases when the underlying stock’s price decreases, and decreases as the underlying stock’s price increases (negative relationship).

Example – Trailing Stop as an Absolute Dollar:
Suppose the stock price ABC is on a downtrend. You expect that the stock price ABC will continue to drop further. You bought Put option contracts of that stock at $3/contract, and place a Sell Trailing Stop order, with an absolute Trailing Amount at $0.5. That means the initial Stop Price is set at $2.5.
When the stock price ABC is falling and, as a result, the price of the Put option has increased to $4, the Stop Price will adjust accordingly to $3.5.
If the stock price ABC continues to drop further, and the price of the Put option then rises to $5, the Stop Price will adjust to $4.5.
Suddenly, the stock price ABC stops to drop and begins to increase. Consequently, the Put option’s price will drop. In this case, the Stop Price will remain at $4.5.
Once the Stop Price of $4.5 is hit, the order will convert into a Market Order to sell the Put option contracts at the best available price in the market at that time.

Example – Trailing Stop as a Percentage:
Similar as above, except that you place a Sell Trailing Stop order as Trailing Percentage at 20%.
In this case, the initial Stop Price will be set at $2.4 (= 3 – 20% x 3 = 3 – 0.6).
When the stock price ABC is falling and, as a result, the price of the Put option has increased to $4, the Stop Price will adjust accordingly to $3.2 (=4 – 20% x 4 = 4 – 0.8).
If the stock price ABC continues to drop further, and the price of the Put option then rises to $5, the Stop Price will adjust to $4 (= 5 – 20% x 5 = 5 – 1).
Suddenly, the stock price ABC stops to drop and begins to increase. Consequently, the Put option’s price will drop. In this case, the Stop Price will remain at $4.
Once the Stop Price of $4 is hit, the order will convert into a Market Order to sell the Put option contracts at the best available price in the market at that time.

As you can see here, when setting Trailing Stop as a percentage, the Trailing Amount will get bigger as the Market Price of the security increases.
On the other hand, when setting Trailing Stop as an absolute dollar, the Trailing Amount will remain the same.

For the list of other types of order, go to: Types of Orders in Trading.

Related Topics:
* Free Trading Educational Video: Learn Technical Tips from Dan Gramza
* Option Greek
* Understanding Implied Volatility (IV)
* Understanding Option’s Time Value
* Learning Candlestick Charts
* Learning Charts Patterns