What is a stop loss?

What is a stop loss? A stop loss (also called an auto stop or a stop limit) order is a price level at which your trading platform will automatically close your trade to minimize losses. This protects your trade from unexpected moves in the markets.

When you open your trade, you should specify this level, so that your trade is automatically protected.

You can also get guaranteed stop losses, where your broker guarantees a particular exit price, so you’re protected from the possibility of price slips – however, be warned that you pay a hefty price for this luxury!

But what is a stop loss hunter?

While an automated stop will take the emotion out of closing a trade, it won’t take the emotion out of taking a loss … and traders will often want to blame someone for their trade losses (I’m guilty myself of cursing the platform for stopping me out.)

So what of the conspiracies …

On an individual basis it is unlikely that a market maker is going to spend time hunting down your stop loss (unless you trade very big). However, if stops are being placed at key levels and the overall exposure is high, then there is a theory that institutions are aware of this too and can use the information to their advantage.

I’d be lying if I said I’d never had any suspicions about any brokers, but on the whole, I’m not a fan of such conspiracies. They don’t do our trading psyche any favours.

As ever, we traders can be our own worst enemies. We intuitively place our stop losses at the points where they are most likely to be “just touched out”. Just below that old resistance level … just outside the recent price range … these look like very sensible place for stop losses. But these points leave you wide open to false break-outs before the price reverses and goes the way you intended. Check out this post for how to avoid the stop loss hunters.

What am I suggesting here? That we do away with stop losses?

There are traders who don’t use stop losses – who sit at their screens managing their positions. But just because you haven’t quantified your stop when placing your trade, doesn’t mean that you don’t have one. Whether it’s a cleverly managed exit strategy, or simply the point where the pain gets unbearable (hopefully it’s the former) – everyone has a point at which they will close out their losses.

One supposed “antidote” to stop losses is pairs trading. This is where you have both a long and short position on two similar companies in the same sector. The idea is that if the market moves unexpectedly, one position should “hedge” against the other. In theory, you don’t use stop losses in this type of trading, but that doesn’t mean that you don’t have an exit strategy.

Protecting yourself from the No. 9 bus

I’ll admit that there was a time when I thought I didn’t need stop losses. When I would sit at my screen watching my trades. And when I discovered pairs trading, I simply hedged my positions, turned off my computer and thought I had it all covered.

Then one Monday morning, crossing High Holborn, soon after my wife had had our first baby, I came face to face with a speeding motorbike courier. As my life flashed before my eyes, did I see the smiling faces of my new family? No. I saw my unsupervised open positions spiralling out of control.

Luckily, the courier and I were unscathed, and I phoned my broker to place some stop losses.

Now I’ll never trade without a stop – even if that’s a “catastrophe” stop – i.e. a back-up in case the worst happens! This allows me to cross the road without worrying whether it’ll leave my family destitute. You have to protect yourself from events like … your office losing power … falling down the stairs … or your boss wanting you to do some work rather than sitting at your computer watching trades all day – that sort of thing!

Exit strategies vs stop losses

Of course, “catastrophe stops” aren’t good things to hit – the clue is in the name! Hitting your catastrophe stop is not meant to be part of the plan – so we need another plan for exiting a trade that isn’t going our way.

So, if price point is going to be our “last resort” stop – what other stop indicators are there?

Time is a good one – I’m on a mission at the moment to minimise the time I leave my capital exposed in the market, so I endeavour to enter each trade with a very clear idea of how long I’m going to give it to bear fruit. If it hasn’t hit it’s profit target or its price stop in this time, I’ll close it out.

The other type of exit plan involves technical analysis. What’s key is to be aware of the options you have, and of the benefits and difficulties associated with each one. Price-based stops are a good thing, but there are many other reasons to exit a trade than simply because it’s lost you too much money – perhaps the indicators that got you into that trade haven’t led to the results you were expecting; perhaps it’s being too slow to give you a return and is leaving your capital at risk in the market for too long; or perhaps you simply got it wrong.

The more well thought-out your exit plans are, the less emotive closing out a loss becomes.

Related posts:

Stop loss hunting – how to defend yourself How to set a stop loss