The Importance of A Stop Loss
Posted: February 14th, 2009 | Author: Mo2 | Filed under: Investing | Tags: discipline, dollar stop, Investing, risk, stock market, stop loss, technical stop, trailing stop |Definition
Most humans are undisciplined. While 95% of you reading this article are shaking your head and thinking you aren’t one of them, you probably are. Sure you might live a life that is perfectly orderly and you don’t do things that are out of line. However, when it comes to trading and having to deal with market pressure and bigger figures, your true self is revealed.
The stop loss is simply a price that you set beforehand that you will get out of the market at a loss. This is to avoid a further loss that could potentially wipe out your account. There are different types of stop losses and you should use what suits you the most, there really is no right answer.
The Percentage Stop Loss
With any trade, if you say beforehand that if the security drops by 5% you will exit. Therefore, if you are to buy ABC stock at $30, you will be exiting at $28.50. Although you should have a better reason for a stop loss, this is a great place to start to control your money management.
The Dollar Figure Stop Loss
Similar to the percentage stop loss, you set a dollar figure for your stop loss. In other words, if the ABC stock falls $3 you exit. By using the dollar figure stop loss you can know exactly how much you are willing to lose without having to do much calculation.
The Time Stop Loss
Everyone has a different time horizon for a trade. Extremely short term traders might be looking at 5 second intervals and hope to turn out a profit within a minute. While other traders might be looking to profit in the next year. Everyone’s trading strategies are different and thus so are their stop losses. By using a time stop loss; you can give your trade an amount of time to work. If it doesn’t work then you can just get out with a loss or a profit.
Trailing Stop Losses
The trailing stop loss is more active. When a trade moves in your favour and you don’t want to give back all of your profits in the case that the market comes back, you can put in a trailing stop loss. How you put in your trailing stop loss will depend on you but you could set a percentage of gains that you want to keep. Or you could also move the trailing stop loss every time the market moves x ticks in your favour.
Technical Stop Losses
These stop losses are placed using technical indicators. For example, if you see a trend and you can draw out the trend lines, you want to put the stop loss below this trend line. There are various technical indicators such as the double top (or bottom) that you could help you place your stop loss.
Why Stop Losses Aren’t 100% Safe
The most obvious answer is, if a stop loss is hit you lose money. It’s unfortunate but it happens all the time, and you have to live with it unless you’re a genius trader with a 99% winning percentage. With a string of stop losses not only does it hurt your trading account; it can also be demoralizing mentally. It really is tough to go on a losing streak sometimes and if you don’t correctly place your stop losses it can really hurt you.
Sure if the market is against you even if you do place proper stop losses it can still hurt you. However, if you place your stop losses too close to the trend line or a technical level, then you’re just asking to be whipsawed out of the market. The market is not a perfect place and just because there is a strong uptrend, doesn’t mean that you will see the occasional whipsaw or spike to the downside. Anything can happen.
Mo2 Thinks
There are a variety of stop losses and although I didn’t go through all of them I think I gave you a good idea as to what is available. You can be creative with your stop losses because stop losses are a huge part of your money management. Sure you need to take into consideration as to how big your position will be. But by implementing stop losses you can take on bigger position sizes and control the amount of money you might lose.
Obviously, you don’t want to always be thinking about losing money. But in reality, traders with plenty of experience are being stopped out everyday. It takes great discipline to put in a stop loss sometimes. And it also takes even more discipline to stick with a stop loss. I’ve been guilty of moving my stop loss in the opposite direction because I was afraid of losing money. Never do this because you’re only asking for more trouble. If the market has come down close to your stop loss then most likely it will go right through it eventually.
It’s really tough to find the perfect stop loss, if there is such a thing. I revert to all sorts of stop losses from time to time. I often use dollar stop losses because it’s easier when I have an idea as to how much I want to risk on a trade. With other trades I use technical stop losses because I know exactly where the trend line is. If I am in front of the computer I use trailing stop losses so that I can maximize profits. Try out all sorts of stop losses until you have a good idea as to what works for you.
I’m reluctant to say do what is comfortable for you because doing what is comfortable is usually the last thing you want to do with trading. However, I do believe that you can make trading relatively stress-free. It just depends on how involved you are in the markets. If you can come up with a decent system and place proper stop losses among other factors then you could have a relatively comfortable trading while having decent returns.
Stop losses are essential however. The first time I had a margin call, didn’t put a stop loss in for at trade that was open forever. In the end, the market took a dive and that killed one of my accounts. Although I have recovered somewhat, having to recover is not something I want to do again, I’d rather make my account grow then have to worry about getting back to where I was originally. Stop losses can help you contain these devastating losses. We need to make mistakes to learn and no matter how many books you read, you still need to experience these mistakes yourself.
It’s easy to say, “Oh yeah, I can easily get out of that position when it’s going against me.” Think again, when you’re long 100,000 units of the GBP/USD pair and you’re down $2,000 unless you’re a seasoned trader I bet you’ll start praying for the market to turnaround. If you aren’t praying and can take the loss then you just might have what it takes to become a successful trader. Good luck!
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