By Sean Hyman, Currency Analyst
www.worldcurrencywatch.com

Let me go on record right now as saying a trailing stop is one of the most MISUSED orders out there in Forex.

At first glance, it appears that if you put in an order and a stop with a trailing stop, then it seems like you’re guaranteed to capture a profit. However, this is not always the case. 
A trailing-stop is the order you use when you are “right” on a particular trade.

A trailing stop does NOT replace a regular stop-loss. In fact, you use a trailing-stop in addition to your regular stop-loss. It’s really two separate instructions for the exact same trade.

When you place a trade, you always add a stop-loss. Then your trading software will automatically close out your trade if the price reaches your desired stop-loss.

However, the trailing stop tells the exact same stop-loss to move forward by a certain amount.

Here’s where people get confused: They think ANY advancement is a profit for them. However, they are thinking about the pair moving and not where their stop is moving from. In reality, your pair still has to move a certain amount for you to make a profit, whether your stop-loss is moving.

Here’s an example: Remember, earlier we were buying USD/JPY at 98.00 with a stop at 97.00. If we add in a 30 pip trail to that, each time the pair moves 30 pips from where we entered the trade, then the stop-loss ALSO advances by 30 pips.

So if the pair moves from 98.00 to 98.30, then our stop-loss moves from 97.00 to 97.30. Yes, our stop moved, but you will notice that it doesn’t mean we are profitable on the trade. In fact, we are still 70 pips away from breakeven. Our trail-stop has to “hop” in 30 pip increments three times for us to profit.

Two Correct Ways to Use a Trailing Stop

How do you solve this problem so your trail stop guarantees you lock in profits? There are a couple of ways.

1. Place a trail stop that is wider than the distance between your entry and stop level. Example: Buy USD/JPY at 98.00 with a 50 pip stop at 97.50. Now I also add in a trail stop order for 60 pips. Since my trail stop is wider than the distance of my regular stop, if it moves up, it ensures at least some profit. In this example, once the USD/JPY pair moves from 98 where I got in, to 98.60, the trail stop kicks in and “hops” instantly up 60 pips from 97.50 up to 98.10. Therefore, I’m for sure 10 pips in the profit in this example.
2. Only use a trail stop once your trade has moved enough that you’re at break even, even if your stop-loss is triggered. Once you’re at breakeven, any trail-stop will lock-in profits. Example: So if I took that same USD/JPY trade and when the pair moved from 98.00 to 99.00, I manually moved my stop up to breakeven at 98.00. Then I can add in a trail stop of ANY size, then it will surely lock in profits IF the pair continues upward by the amount of the increment we chose.

Now Here’s WHEN You Should Use the Trailing Stop!

So when should you be using these anyway? Because it’s not a good idea to use them all the time. (However, a regular stop should be used on EVERY order to protect your trading account.)

Here’s the answer. Trail stops are BEST used when a strong momentum type of move is happening. It’s when you see the price going so strong that the angle of the trend slope is very steep. This is where the trail stop is best used.

Why? It is most likely to kick in the trail and move up. It also shows a strong trend. If you’re in a strong trend, you want to soak as much as you can out of it. Thus you don’t want to “cap” your gains with a limit order, so you place a trail stop instead.

When do you NOT want to use a trail stop? You don’t want to use a trail stop when the pair is in a sideways range (no trend) or when it’s in a very mild trend. Think “trailing stops” when you see huge, momentum (fast, steep) moves in the pair.

In other words, you use a trail-stop when you are in a pair and the profits are coming very quickly in a short span of time.

If the pair is in a sideways range, then just put in a regular stop and a limit where the pair comes to the other side of the range.

Also, some pairs tend to be quicker movers than others. For instance, GBP/JPY is known to be a quick mover much of the time. It can clear hundreds of pips each day in a small span of time.

So a “fast moving” pair is ideal for trail stops. However, a “tame” pair like CHF/JPY typically wouldn’t normally be a great pair to use a trail stop with because its moves are not that quick and fast typically. However, if it ever were to fit that criterion, then by all means, you can implore the trailing stop.

So I hope this helps to clear things up.

One final note: Practice using your first couple of trailing stops on your broker’s demo account. That way you aren’t risking hard earned dollars while you make sure you are getting the order in right.