The biggest misconception people have about stop loss orders

 

Why do you trade with a stop loss?

Is it because you’ve been told to? Because your broker automatically applies one? Because you’re scared of being wrong?

There are traders out there who’ll tell you they never use a stop loss order. They might tell you that it shows a lack of conviction in your beliefs, or that stops cost you money.

I’d never advise trading without a stop loss order. However, it’s important to know what your stop is actually doing, whether it’s really saving you money, or just giving you a better night’s sleep.

Do stop losses cost money?

Tests have shown that any kind of stop loss order will hurt the long-term performance of a trading strategy. If you have no stop on a trade, you’ll just be sitting on unrealized losses until the price (eventually) reverts back.

Thomas Bulkowski (http://thepatternsite.com/) ran a test in which he bought a stock, used a daily trailing stop and left the trade open for a month (unless it was stopped out in the meantime). The results showed clearly that the buy-and-hold method with no stop loss did the best. And that the closer the stop is to the current high, the more money you’ll lose, as stops take us out of trades that are ultimately profitable.

No matter where the stop loss order is placed, it hurts performance. The tighter the stop, the worse the performance. Amazingly, even stops as far as 50% away hurt the performance.

Trading without a stop is a very long game, and would require unlimited resources to play. So it’s a game just played in hypothetical terms!

Back in the real world however, we have limited resources, margin requirements, and bills to pay. Plus, I want to show you a way that your stops can pay for themselves, so you get a better income PLUS the benefits of trading within your comfort zone.

If stops cost money, what are we using them for?

Let’s consider what would happen if we didn’t use a stop loss order … We’ve placed a trade and the market is moving against us. We’re showing a loss, but we’re still confident it’ll come back. As the size of that loss increases, we might get to a point where we feel we just can’t ‘afford’ to close out that loss – instead we have to hold onto it, in the hope that it’ll come good.

Of course, it might come good, but if it doesn’t, you’re probably going to see a margin call on your account and that loss will become very expensive.

We all have a point of pain – and the closer we get to that point (or if we slide beyond it), the worse our decision-making becomes.

Psychologically, trading with big losses is the toughest way to trade. This is why many traders are prepared to accept a low success rate, in return for a positive risk-reward ratio. (If your losses are half the size of your winners, you’re likely to lose more than 50% of your trades.)

Stop losses are vital to keep us within our comfort zone, where we can keep making clear, calm trading decisions.

But we shouldn’t knock the major psychological advantage you get from not suffering big losses – this is what keeps us in the trading game for the long term, rather than risking suffering a drawdown that ends our trading career.

So, here’s how to make your stop losses pay for themselves

As well as their psychological advantages, stop losses also have an important role to play in wealth-building.

Many of us apply compounding to our trading accounts, so profits are reinvested, and losses will see a reduction in our staking levels.

Compounding is a wonderful thing – sometimes described as the 8^th wonder of the world. It is the only way to turn an acorn of a trading fund into an oak-tree of substantial wealth. However, there’s one thing that compounding hates – and that’s volatile returns.

During weak market conditions, negative compounding comes into play, where drawdowns mean that our stake sizes are considerably reduced, and we are left playing catch-up for a long time.

This is where stop loss orders, including trailing stops or moving stops to breakeven really come into play, by minimizing losses or capturing some profit from a trade. This smooths out our profit curve, and creates the conditions where compounding really hits its stride and starts to build serious wealth.

When you’re working out the most profitable way to trade, it’s important to apply compounding to your results (assuming that’s the way you’re going to trade). Just looking at what brings in the biggest profit with a fixed bank is not necessarily what’ll bring you the best results long-term.

 

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