Always have a stop loss

Posted By Robert On Saturday, January 25th, 2014 With 0 Comments

Now I know this will spark a debate on the merits or otherwise of stop losses and they are usually argued in the negative by those that set stop losses too close or aren’t quite at the emotional maturity level of a seasoned trader.

Not having a stop loss is like driving a car without insurance – nothing may happen and you may be a very responsible and diligent driver, but one day (or in trading many days) your numbers come up and you will lose. A stop loss is the ‘insurance’ (a small price is paid to help reduce the cost of an even bigger loss) and provides some cover in the event a trade goes against you.

If you still need convincing, think for a minute – is it easier to reduce risk or easier to make a bigger return? Looking at the following table, if we sustain a 10% loss, we need to gain 11% on our new balance to get back to where we started. If we lose 50% of our float, we know need 100% return just to get back to breakeven. Many people can‟t even picture making that type of return yet they will run their float down to 50% without too much concern. Long term survivors focus more on risk management than they do on astronomical returns. You need to be in the game to win and for this you need to have your trading float intact. A stop loss is part of the risk management strategy.

Risk Management Stop Loss

You must always have a pre-determined place to exit a trade and this forms your stop loss. With CFD providers there are many different terms and conditions so you will need to read about this in their Product Disclosure Statement (PDS) and understand it clearly before you trade. In particular you will want to know:

  1. When placing an order, how close can I place a stop loss order to the current price? Some have set points. Others have multiples of the price spread which is OK unless you trade CFDs that have wide spreads.
  2. When placing an order, do I simply set the trigger price or is there a maximum range I have to be within? Many DMA providers in Australia are limited to a maximum 7c range that a stop can be placed in so that if the range is breached before your stop order is filled or the price gaps over this you can find yourself high and dry with no active stop in the market.
  3. What happens when a stop loss is triggered? Most Market Maker (MM) CFD providers convert a stop order to a market order when the price point is triggered and you will get filled at the next available price in partial fills or totally filled if there is a matching quantity depending on the provider as demonstrated below:
  • Assume you are long with a stop loss order for 6,000 shares at $7.81 which has just been triggered by a transaction going through at $7.81.
  • The stop sell order is triggered and the MM may at their discretion see that the next available quantity to buy at your quantity (6,000) is at $7.76 so you are transacted at that.
  • The Market Maker makes extra money whereas you should have been sold at an average of $7.79.
  • To add insult to injury, if the trigger price of $7.81 was not breached in trading and in fact the price started matching above this for the rest of the day, you would have been sold at a price 4c below the price actually traded on the day – OUCH! Not all Market Makers will do this but you must read the provider‟s PDS carefully and ask the question if you are concerned. For this reason alone many traders avoid the MM‟s that have the discretion to fill orders this way.

Market Depth

  1. Is there the opportunity of a ‘Guaranteed Stop Loss’ order whereby you pay a premium and are assured of getting out at the exact price you set your stop loss? Whilst only normally provided by MMs and not used regularly due to the other limitations also imposed, this can be a great tool if the market is getting jittery, you are getting jittery or you find yourself over-leveraged.
  2. How is the DMA order filled? Most DMA CFD providers action a stop order trigger as a limit order which will have a set maximum price range and if this is breached your order may not get filled e.g. Stop Loss at $7.81 to a limit of $7.75 so if the traded price gaps below this range, your order will sit in the market unfilled whilst the market can continue down. If you diligently check your stop loss orders you will minimise this slippage with a new order the next day or take the time to exit at market the next day. In trading you have to accept that sometimes this slippage will happen but overall you are better off than not having stops at all.

Which is best for you? This is a difficult question and should be determined over the results of 50 trades not the emotional results of one or two trades where the slippage is high. From one view the MM approach is better in that it assures you that you will get out of a trade, even if the market goes heavily against you – after all the price hit your predetermined ‘get out’ point and you should be committed to exit at whatever price it takes. Whether the price recovers or continues to go against you, you wanted out at a price target and the market order approach does this efficiently, albeit not always at the point you wanted. On the other hand, why pay this MM slippage that can happen regularly on thinly traded stocks when it may only be on occasion that the DMA price range is gapped over? You will need to balance out the pros and cons against your trading method and the other considerations when selecting a provider.

The next issue is whether to have ‘in market’ stop orders or ‘out of market’ stop orders. ‘In market’ means you have a physical order placed with your CFD provider (online or by phone) and sitting in the market. This is good if the market goes crazy during the day and at least you are out. While it can also save you, there are times when the market will move through your stop loss and then continue moving further away and when the craziness is over, finish back in the money for the day near where it opened. This happens to us all and many traders take this personally and hate losing even a single trade so avoid in-market stops.

‘Out of market’ stops are where you keep track of your exit points each day and wait until it is breached based on the close of the day and then sell the next day. This approach is arguably better as it balances out some of the short term panic that can happen in the market and works on the more stable closing price. Whilst this is a more logical approach, the reality is that this is a manual system and life sometimes gets in the way of our trading career. All you need is to be travelling, have an accident, be distracted by a pressing personal matter or be sick and you may have missed checking your stops for a day or two and find the market has dropped significantly and taken a large portion of your money with it. If you held one position and it dropped 8% over 2 days, then multiply this by your leverage of 5x and you could be down as much as 40%. This again highlights why leverage should be managed and you should consider diversifying your positions within a portfolio. This is where I could slip in another discipline lecture about why you should decide on a stop loss method and stick to it, but I won‟t. You know you should and it will be another sign you are treating your trading professionally, when you choose and religiously stick to a stop method.

Due to the leverage factor, I believe stop losses are warranted and may one day save you a catastrophic loss. If you believe stop losses are causing you to get out of trades early, then the stop is too close, your placement methodology is not suitable or you haven‟t got your head around the fact that trading is about accepting winning and losing trades and making sure that overall your strategy ends in greater wins than losses.

We always need money in our account to trade and one or two big losses are all it takes to put us back for years. Accept that stop losses aren‟t perfect but that they are there as insurance and sometimes we win from this, sometimes we lose but you need money to be in the game and so risk management is often more important than big wins that can be lost just as quickly.

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