The Stop-Loss: Safety Net or Trap?

One of the most basic skills drilled into newbie traders is the use of stop placement with their buy or sell orders. The staff at NetPicks.com details what a trader should consider before determining whether or not to use them.

The nature of trading is that you win some and you lose some. Knowing when or where you’re wrong therefore can make all the difference between success and failure in this game. Some people struggle with taking a losing trade because they don’t want to lose money. But then many also struggle because they do not have a well-defined exit strategy and so they’re not sure of when they should be exiting for a loss. After all, no one likes being high- or low-ticked out of a trade, do they? So it is that this little seemingly innocuous order type, the stop-loss, throws up so many technical and psychological challenges to deal with before it does what it really should do—protect your account.

The illusion is that the stop-loss order itself is the issue. But it’s merely an order type, which executes at market when the price at which it was placed is traded. Nothing more, nothing less. In reality, the protection offered and the problems created by using this order are generated by the trader. So it is the responsibility of the trader, like everything else in trading, to analyze how a stop-loss order can be used and whether it is appropriate to a specific strategy. By doing so, the trader can have the confidence to stick with the order when a trade results in a negative outcome. Let’s take a quick look at some of the considerations.

PROS

  • You can define what your risk is on an individual trade.

  • Stop orders are lodged at the exchange and so if your power, PC, or Internet goes down or there is a problem with your broker feed, you should be protected against a large move against your position. This can be just as useful if you enter positions using a limit order. If you don’t place a stop order before you’re filled on your entry, then if any of the scenarios outlined above occur while you have resting limit orders in the market, you could be filled on your limit order (again, because the order is lodged at the exchange) and the market could then continue to move against you.

  • Deciding where you will exit a trade before you enter it will help prevent your judgment from being clouded by “in the line of fire” emotions. A physical stop order is a visual reminder of exactly where you’ve determined you’re wrong.

NEXT PAGE: Other Things to Consider

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CONS

  • If you’re using a stop-loss order in a market with lower liquidity, due to the fact that a stop becomes a market order when it’s triggered, it’s more than possible you won’t get the price you placed your stop at. Therefore it’s also possible that you won’t be able to exactly define what your maximum risk on a specific trade is.

  • It can be easy to rely on a stop order. A stop order is really a maximum loss you’re willing to take. Some strategies may take their exit cues from aspects other than price.

  • Psychologically it can be pretty tough when your stop is executed when the market moves only a tick or two through your price.

  • I think it’s pretty obvious that for many people a stop-loss is a good idea. But even if for whatever reason you feel differently about this and wish to trade without one, there’s always the chance that the pre-determined technical exit point for a losing trade or the maximum loss per contract won’t be respected by the trader. The reasons for this can be down to one or more of the following points.

ISSUES

  • Fear of capital loss or more frequently, not wanting to be wrong on a single trade.

  • Ambiguity of loss exit plan. Not having something to “lean” on to technically delineate where the trade loses validity.

  • Ambiguity of entry plan. I always say that there’s more to risk managing a position than knowing how much pain or how far offside you are willing to tolerate before exiting a losing trade. If you enter at poor prices technically, you could well be taking yourself out of a position before you’re wrong (unless you use position sizing) and this makes it much harder to justify adhering to your stop.

  • When markets “creep” towards your stop, it can feel like prices aren’t going to go much, until they do that is. This can either be when a load of other traders decide they’ve had enough beyond a certain point and it does accelerate or it can be just one of those days where it grinds through prices with virtually no acknowledgment of them.

When it comes down to it, stop-loss orders are a useful way to limit your risk if you plan how to use them properly and then adhere to them. They can be used to limit risk from the market and limit risk from you. The trouble is that traders often do not take the responsibility for their stops and so don’t work out a proper plan to use them. Because of this, it can be much harder to stick to arbitrary limits created because you know you need something. This is the “well I guess I should have a stop” mentality and to me, it doesn’t work well at all. So take the time to properly assess how you should be using your stop-loss orders and make sure they are used for what they were meant for—to protect you.

This article was written by the staff at NetPicks.com.