This is one area I had for years struggled with when I first began investing and trading.
I’ve been recently showing my readers of my own stopped out trades, and a friend of mine actually came to me to ask how best to set them (he was actually embarrassed to ask me thinking it was a silly question but I said that only unasked questions are the silly ones).
It’s probably true to say that stop losses seem to bring many people unstuck.
So what I want to do here is the following;
- To clear the myth about stop losses
- Explain why they are important and a necessary evil
- Show you the different types of stop losses
- Demonstrate how to best set them up
- In addition, show how I personally use them in the real world and in the hedge fund I run
Many seminars and ‘gurus’ talk about stop losses, some even tell people to find brokers who have ‘guaranteed stop losses’ (which I personally think are unnecessary since they charge a lot for this priviledge), but not many have actually fully explained the ins and outs of stop losses and how best to set them up.
The common myth about stop losses is that once you set them, the whole market gets to see your order and hence they (the market participants) will conspire to drive down the stock you hold and hit your stop loss at the exact price to take of you your stock on the cheap and then run the stock back up.
Firstly, I would like to say this is ludicrous, especially if you are trading in very large cap stocks like those within the S&P500. Can you imagine the amount of stock that needs to be sold just to ‘force’ the stock down to your price so they can buy the small amount you hold? This doesn’t even sound rational, does it? I can tell you, this will not happen.
However, even if you are still afraid of this occurring, there is another solution that I will explain a bit later which can help you hide your order so the market will not be aware of your stop loss.
Another common myth is that you really do not need hard stops, just a mental stop loss so you can adjust to market conditions and be flexible to market changes as they happen.
I am here to also tell you that mental stops are easy in theory, hard in practice. Why?
Just imagine you have just bought a stock you think will go up and you have a mental stop you say to yourself I will get out at the so and so price. Instead, the moment you buy the stock, it begins its downward decent and has now lost 10% of its value due to some bad news. How would you feel?
It has just passed your mental stop loss and you are ready to ‘calmly’ put on the order to exit the position and move onto the next trade right?
I will tell you from experience even after almost two decades of being involved in the market, all calmness goes away when you are on the spot and money has now been lost. Calmness and clear thinking only comes back after you are out and no longer have any vested financial interest.
Which is why I say that mental stops work well in theory when the event has yet to occur, but goes out the window once you are at your stop loss point staring at your loss.
Stop losses are important, simply because they protect not just the position you are currently in, but also the overall portfolio from ever having one bad trade ballooning into a disaster and affecting not just the trade but now the entire portfolio.
One of my mottos I live by is; no one trade should ever make you or break you.
It is just one trade among the many thousands you will complete in your lifetime if you choose to actively pursue trading and investing.
Another reason why trading stop losses are important is that they will put your mind at ease and let you sleep better knowing that protection is always active on every trade position you have.
Finally, depending on the level of trading you do, set stop losses allows you to never lose track of the positons you hold. Personally, I can at times depending on market environment and opportunities hold between 100 to 150 positions. Can you me keeping mental stops on each and every one? Just aint going to happen and still function day to day.
There are many types of stop losses but I will go through the two most important ones.
As I mentioned, most people may just set up a hard stop loss visible to the whole market. An alternative is to set up what is called a ‘conditional’ stop loss, which only triggers when a certain condition you set is met.
Personally, I use conditional stop losses as it fulfils two benefits. My stop loss is in place the moment I’m in the position and will only be triggered if for example the stock price drops below a certain value and secondly my order is hidden away from everybody except of course the broker which I execute with. This should override your fear of not setting up a stop loss in case you still believe the market is there to conspire against you. (Don’t worry, I was one of these traders as well when on some odd occasions my stop was the lowest price of the day before shooting right back up)
How best to set your stop loss really comes down to individual preference as it would be irresponsible of me to say which is best since different trading systems require different needs. Some use support and resistance to judge where their stop loss will be. Others use a dollar stop, percentage of stock price drop stop. Others also use trend lines, moving averages, Bollinger Bands and ATR (Average True Range) to set their stop. I won’t go into these technical criteria’s as it’s not my intention to confuse you even more here.
Your stop loss level comes down to your own trading system, the style of trading or investing you do, duration of trades and size of trades.
For example, a day trader is likely to set very tight stops as they trade larger sizes trying to take advantage of small moves and hence need tight stops in case things go the other way.
Longer-term position traders like me leave much larger stop loss room to allow the position to move it’s natural course so as to not be affected by normal everyday volatility noise. Of course, the drawback of this is that the losses then tend to be slightly larger than the traders who have much tighter stops, but the advantage of this is I get to ride out normal everyday movements without being constantly affected and running up brokerage costs.
However, no matter what type of stop you choose to use, stop losses are a necessary evil and should be used in conjunction with set conditions to be triggered. This way you really have no excuse to trade without them.
Remember, mental stops do not work in the real world so make sure you set them up immediately after you have entered in the position. After a while, stop losses become such a habit that not having them feels very uncomfortable.
So begin to use stop losses today, there really is no valid reason or disadvantage to avoid them. Stop losses will protect you from the downside and enable you peace of mind to pursue the upside.
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