Stop Loss Orders: If the market moves against your position, stop loss orders are used to limit losses. If you dont use stop loss orders, you are leaving yourself at the mercy of the markets. A perilous proposition! Stop loss orders are critical to your trading survival. The traditional stop loss order does just that. It stops losses by closing out an open position that is losing money.
If you are small, your stop loss order would be to buy but at a higher price than the current market price. Stop loss orders are on the other side of the take profit orders but in the same direction. If you are long, your stop loss order would be to sell but at a lower price than the current market price.
Trailing Stop Loss Orders: A trailing stop loss order is a stop loss order that you set at a fixed number of pips from your entry rate. As the market price moves, the trailing stop order adjusts the order rate but only in the direction of your trade.
Suppose you are long on EUR/USD at 1.2654. You set the trailing stop loss order at 30 pips. The stop will initially become active at 1.2654-30=1.2624. If the EUR/USD rate goes up to 1.2674, the stop adjusts itself and will become active at 1.244. The trailing stop loss order continues to adjust itself higher as the market moves higher.
When the market puts in the top, your trailing stop will be 30 pips below the top. If the market ever goes down by 30 pips from the top, the trailing stop loss order will be triggered and your open position closed. So in our example, you are long at 1.2654. You set the trailing stop loss at 30 pips. The stop order will become active at 1.2624.
If the market never ticks up instead goes straight down, you will be stopped out at 1.2624. If the market first rises to 1.2664 and then declines 40 pips, your trailing stop loss order would have first risen to 1.2664-30=1.2634. Thats where you would be stopped out.
You must have heard the saying often while trading: Cut your losses and let your winners run. A trailing stop loss order allows you to do exactly that. The thought is that in case of a possible winning trade, you wait for the market to stage for a reversal. The trailing stop loss order takes you out of your trade instead of you picking the right level to exit on your own.
Use of stop loss orders is critical in money and risk management. Never ever, trade without the stop loss orders! So the key to successful trading is to cut losing positions quickly and let winning positions run. This function is nicely performed by the trailing stop loss order.