5.8 Trailing Stop in Trends - Let Your Profits Run and Cut the Losses Short

Trailing Stop-loss.
"Man, this stock used to be at ninety bucks a share, and now it's all the way down to $40.  What a steal!"
Wait! It may be that you trying to catch a falling knife. If you are not very, very careful, you are likely to get cut. The above analogy applies equally in the Forex market. You may ask as to what this has got to do with trailing-stops, right? First, let’s continue with the story.
How are you so sure that the pair has really hit bottom? It may be in a severe bear grip, and you really don’t know how long or how severe the bear market may be. You might be mistaking a retracement bounce for a trend reversal. So, act with caution. Because not knowing the difference between a retracement and a reversal can give you pip-less accounts and sleepless nights!
Similarly in an ongoing trend, when the price starts moving in the opposite direction and you immediately close your entire position, you may have stopped yourself from taking the full advantage of the ongoing trend.
Difference in retracements and trend reversals.
We have already seen that trends can continue for weeks to months to years and yes, sometimes decades. During any trend the retracements or corrections take place quite often but reversal would happen only once. 
Let’s see why the market retraces and why it reverses and how to play our game to be safe and to maximize our profits.

Reasons Behind Retracements

No one can predict when the market would reverse and hence no one would wait for the trend to end for realizing the profits. Profit bookings keep on taking place every now and then during any trend. It could be only for the purpose of profit taking or may be fueled because of some minor negative news or economic release.
Every such event will cause the prices to retrace before the trend resumes.

Reasons Behind Trend Reversals?

Long-term trends only reverse due to change in basic fundamentals which tend to shift the entire market sentiment. The reversed trend, in such case, may again go on for a long time.
Well, let's take a short break here to get back to the subject of trailing stops to see what exactly a trailing stop is, before diving into further into the subject of "trends and trailing stops".
Trailing stops are stop-loss orders which trail the price action or move with the price-action when the price moves in your favor. You get into a long position and the price moves up strongly as you had expected – you keep on moving your profit targets up to get the full advantage of the bull-run but forget all about that poor guy known as your stop-loss order. What if the trend reverses and price falls equally strongly. That poor guy would turn out to be a killer for your position. You will not only lose the opportunity to realize the possible profits but will end up in losing money on an otherwise profitable trade.
What if you had moved your stop-loss order up when the price had moved up? And what if you had kept on moving your stop-loss order up and again up when the price had moved up and again up? You would have come out shining with a bucket full of pips.

Example of Using Trailing-Stop During a Trend

The following chart is not just a chart but will tell the life story of a trade during a trend:
A complete life cycle of a trade with trailing stop loss. 
Let’s do a complete dissection of this trade, including why the trade was made at the first place.
  • Prior to point “A” GBP/USD was in a volatile sideways movement. 


  • Point “A” offered resistance and price fell to point “B”. The support at “B” broke over “A” to reach “C”. Such a move indicated the possibilities that price should move further up but instead the price fell strongly below the support zone of point “B” and this fact brought in the bearish sentiments.


  • Recovery from point “D” found some resistance at “E” which was close to the previous resistance zone of point “C”. A break over that indicated that chances of further gains are very good as both of the previous resistances were taken out. We enter a long position with this break. The stop-loss order was kept, as indicated by “SL-1”, slightly below the recent support level.


  • In zone 2 we saw some resistance but the fall did not sustain. When the price recovered after the short fall, we moved up the stop-loss to the level labeled as point #3. This level was slightly below point “E” as we expected this previous resistance to act as support now.


  • Price broke away the resistance of zone 2, as indicated by point #4, and with that break we moved the stop-loss level further up to the level marked point #5. This level was slightly below the low of the zone 2.


  • With the breakout from the zone 4, labeled as 6, the stop-loss was moved again and this level is marked as point #7. You will notice that this is again slightly below the recent support of the zone 4.


  • Similar to the above points, the actions were repeated and the last stop-loss level was marked as point #11.


  • All of a sudden the trend reversed. A reversal can never be predicted and the stop-loss at point #11 was hit. The outcome was that we ended up with a profit worth the pips from point 0 to 11 and these were some enviable over 800 pips.
What if the stops were not trailing the price-action? Either we would have come out of the trade, without having the patience to take the full advantage of the trend because of risk appetite or we would have ended up in losses instead of profits.
This was a perfect example of the famous words “let your profits run and cut your losses short”.

How does the trailing stop loss function?

Very simply, the trailing stop maintains a stop-loss order at a preset percentage below the market price (or above, in the case of a short position). The stop-loss order gets adjusted continuously in line with the fluctuations in the market price, always maintaining the same percentage below (or above) the market price. The trader is secure in the comfort of knowing that in the event of the market reversing, he would have at least some pips in the bag, guaranteed.
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