Stop loss orders are a trader's best friend. Most new traders think that if they can learn the newest / best / most accurate way of forecasting the market movements they will have the key to untold riches in the market. After trading for a while these new traders are inevitably disappointed with the results of this search for the Holy Grail.
Why? Because they have not learned to limit their losses – they need stop loss orders!
Understanding the trading profitability equation shows that limiting losses and protecting capital is the key to first surviving and then trading profitably. No trader will remain consistently profitable until they learn how to control their losses. This is true whether you trade Forex, Futures, Bonds or the Stockmarket.
Having an automatic mechanism to limit your losses on every single trade will help prevent one trade from becoming a monster loser (or many trades becoming large losses) which eats into your trading profits. The stop loss order is this mechanism.
A stop loss order is an order that you place when you open a trade which will automatically close your trade if it moves against you by a certain amount.
For example, lets say you are buying ABC stock at $50 per share and you think that if it drops to $45 per share you must be wrong on the trade and you want to get out. If this was the case you would place a stop loss at $45 so that if the price dropped that far your order would be executed and you would be out of the market.
The stop loss order remains dormant until the stop price is hit. At this time it is placed into the market as a market order and will be executed at the prevailing price.
The main benefit of stop loss orders is that they allow you to predetermine the level at which you want to exit the trade. If that level is hit, you exit! This takes the emotion and second guessing and hope out of the exit. If the level is hit you exit.
One of the biggest mistakes traders make is holding onto a losing position hoping that it will turn around…when it doesn’t the results can be disastrous!
As a system trader I don’t care what any one of my positions does. I know that if I design a trading system for the Stockmarket, Futures or Forex which cuts my losses and lets my profits run then I have a good chance of a profitable trading system. Executing this system consistently over many many trades generates the profits I am looking for.
Every trading system that I design has stop losses. This ensures several things:
There are two drawbacks of using stop losses that traders should be aware of. Neither in my opinion warrants not using stops because the benefits are so great.
The first drawback is that an intraday volatile spike in price against your position could stop you out during the trading day only to reverse and end up back where it was or higher.
This can be immensely frustrating and makes it very tempting to stop using stop loss orders. What you probably don’t realize though is that this is just a small price to pay for all the times that your stop loss orders get you out and the market keeps moving against you.
Trading profitability is not about milking the most from any one trade. It is about designing a trading system that fits you, has a positive expectancy and executing it consistently over time. So my suggestion is not to focus on the few times the stops force you out early, but focus on the design of your trading system, including stops to limit your worst case loss.
The second drawback of stop losses is that they can incur a lot of slippage if you trade thin or illiquid markets.
Slippage is a fact of life in trading, however you can mitigate it by trading highly liquid instruments. Even though illiquid instruments can give you a lot of slippage with stop loss orders, they can move even further against you if you don’t get out when you should.
My personal opinion is that it is better to get out with some slippage than to stay in and risk the trade moving even further against you, but that is just my opinion – you need to design your system based on your objectives and beliefs to fit you.
Protecting your trading capital by placing a stop loss on every trade is a great way of introducing discipline into your trading. It helps ensure you exit small losing trades before they become big losing trades. It also eliminates one of the big psychological problems new traders have – Taking Losses.
Regardless of how or why you use different order types, they should all be documented with reasons and instructions in your trading plan to ensure you (or the person placing trades for you) know exactly what you need to do in all situations. Review our discussion on how to build a winning trading plan here.
If you do not yet have a completed trading system then I recommend you read our description of the Trading System Development process before getting started.
I also suggest you seriously consider Van Tharp's home study program "How to develop a winning trading system that fits you". This program will guide you through all of the steps required to build a profitable trading system that you feel comfortable trading because it fits your personality and needs.
Of course nothing is guaranteed, but shouldn’t you take every step possible to help yourself succeed?