What it is:
A trailing stop is a special type of trade order where the stop-loss price is not set at a single, absolute dollar amount, but instead is set at a certain percentage or a certain dollar amount below the market price.
When the price goes up, it drags the trailing stop along with it, but when the price stops going up, the stop-loss price remains at the level it was dragged to.
A trailing stop is sometime referred to as a trailing stop-loss.
How it works (Example):
For example, you buy Company XYZ for $10. You decide that you don't want to lose more than 5% on your investment, but you want to be able to take advantage of any price increases. You also don't want to have to constantly monitor your trades to lock in gains.
But if the stock goes up to $20, the trigger price for the trailing stop comes up along with it. At a price of $20, the trailing stop will only trigger a sale if the stock drops below $19. This helps you lock in most of the gains from the stock's rally.
In the example, you could also decide you don't want to lose more than $2 on your $10 investment. If the stock goes up to $20, the trailing stop would drag along behind the price and only trigger if the stock falls to $18.
Why it Matters:
A trailing stop can be good for investors who may not have enough discipline to lock-in gains or cut losses. It removes some of the emotion from the trading process and offers some capital protection automatically.
There are some drawbacks to consider. First, you need to consider your trailing stop percentage or amount very carefully. If you're investing in a particularly volatile stock, you could find the stop level triggered fairly frequently.
Finally, excessive trading can quickly turn into "churning," with fees and commissions eating into your profits.