A trailing stop is a type of stop loss order that combines elements of both risk management and trade management. Trailing stops are also known as profit protecting stops, because they are used to keep a particular amount of profit in addition to preventing a loss. Trailing stops are supported by most trading software, and are usually implemented by the trading software as opposed to a brokerage or the exchange.
How a Trailing Stop Works
A trailing stop is initially placed in the same manner as a regular stop loss order. For example, a trailing stop for a long trade would be a sell order, and would be placed at a price that was below the trade entry (and the exact opposite for a short trade). The main difference between a regular stop loss and a trailing stop is that the trailing stop automatically moves as the price moves. For example, for every five ticks that the price moves, the trailing stop would also move five ticks. Trailing stops only move in one direction (with the trade), so if the price moves with the trade (i.e. into profit) the trailing stop moves with it, but if the price moves against the trade (i.e. taking profit away) the trailing stop stays still.
For example, if a long trade is entered at 4000, a ten tick trailing stop might be placed at 3990. If the price then moved up to 4010, the trailing stop would move to 4000. If the price continued up to 4020, the trailing stop would move to 4010. If the price then moved back down to 4015, the trailing stop would stay at 4010. If the price continued down and reached 4010, the trailing stop would exit the trade at 4010, having protected ten ticks of profit.
How Not to Use a Trailing Stop
A mistake that is often made by new traders is to place a trailing stop that is too close to the current price (e.g. a one or two tick trailing stop). When a trailing stop is too close, the market does not have enough room to breath (i.e. make its usual fluctuations), and it is very likely to reach the trailing stop prematurely.
Trailing stops should be placed at a distance from the current price that you do not expect to be reached unless the market changes its direction. For example, a market that usually fluctuates within a ten tick range while it is still moving in a single direction would need a trailing stop that was larger than ten ticks, but not so large that the entire point of the trailing stop is negated.
Some traders use trailing stops with every trade that they make, and some traders never use trailing stops. If you do decide to use a trailing stop, it should probably not be your only way of exiting a trade, because most trailing stops are not based upon market dynamics (i.e. they are just an arbitrary stop loss). The only exception to this would be a system trader that has specifically tested and proven this to be the most profitable trade exit for their trading system.