A trailing stop is a type of stock sale instruction given by an investor to a broker. It is generally designed to allow for the maximum possible profit if a stock rises in value, but limit the potential losses if it falls. The order means that the stock is sold whenever it is a fixed amount less than its highest position.
A trailing stop is a type of stop order. This is an instruction by an investor that the stock should be sold as soon as it reaches a fixed market price known as the stop price. A stop order can be higher or lower than the stock's starting price, meaning it limits the profit or loss, or two stop orders can be issued, one higher and one lower.
Most types of stop order simply name a price. A trailing stop order instead details the amount of movement in one direction that will trigger the sale. This means that the stop price will change over time, "trailing" the market price.
An example of a trailing stop would be a stock that begins at $25 United States dollars (USD) and the investor issues a trailing stop of $2 USD. This means that to start with the stop price is $23 USD. If, however, the market price rises to $30 USD, the stop price rises to $28 USD. The set-up means that the stop price can only change upwards. The market price will hit the stop price, triggering a sale, only as and when it is $2 USD below the highest price it reached since the investor issued the stop order.
The trailing stop does not have to use a fixed amount. Instead, the investor can give the order as a percentage. In our example the order would be for 8% and would initially mean the stop price was $23 USD. If the market price rose to $30 USD, the new stop price would be $27.60 USD.
It's also possible to use a trailing stop for buying a stock. In this set-up, the order determines by how much the stock must rise before the broker buys it. The main theory for using this type of order is that if the rise amount is set high enough, the investor could catch the stock as it rebounds from its lowest point.
There are some technicalities that an investor must be certain about when placing a stop order. One is that there are technically two market prices at any time, known as bid and ask, which are the prices available depending whether an investor is looking to buy or sell an order. The stop order must thus make clear which price is to be used.
Another issue is that a stop order is normally a market order. This means that once it is triggered, the broker buys or sells the stock as soon as possible until they have got hold or got rid of the required quantity. Depending how liquid the market is, it's possible the market price may change before this is complete. An investor could instead issue a limit order, which not only gives a stop price, but also a limit price that is the absolute maximum or minimum the broker can buy or sell for. If an investor uses a limit price, there is a risk the broker may be unable to complete selling or buying the entire quantity of stock before the limit price is breached.