Trading professionals frequently employ stop-losses as a risk management method to reduce their losses on a given trade. The trade will automatically be exited when the market price hits the predetermined price threshold. A stop-loss prevents a minor loss from growing into a larger one and is universally acknowledged as a crucial component of any trading strategy. But some stop-loss realities are rarely discussed, like the lack of a guarantee of a quick exit at the stop-loss price level, the impossibility of stopping significant losses on a gap down in price, the manipulation of other traders triggering your stop-loss, and the psychological toll they can take on the trader during volatile markets. We’ll look at these truths in this blog post to help traders handle stop losses more skillfully and with deeper insight.
Four truths about stop-losses
Truth #1: Stop-losses are not guaranteed
Market conditions might cause stop-losses to be triggered, and they don’t always execute at the desired price. When the market moves too quickly for the stop-loss to be executed at the targeted price, this is called “slippage.” The stop-loss order can be filled at a price other than the one the trader intended. This can cause a bigger loss than anticipated, particularly in volatile markets.
Stop-loss orders might not be carried out in some circumstances, such as when a market gap occurs or a broker overrules the order manually. This might happen when a broker manually closes the deal because they think executing the stop loss order would result in a substantial loss for the trader. This might happen, for instance, when there are erratic market movements, technical difficulties, or trading platform problems. For traders at prop firms, a risk manager may also want a trader out of a position even before the stop-loss is triggered due to risk exposure in volatile markets and to exit before news events like company earnings or economic data.
Truth #2: Big losses are not always avoided by using stop losses
Stop losses are designed to cut down on losses but not completely eliminate them. Placing stop losses too close to the current market price is a mistake that traders frequently make, which can lead to being stopped out too soon. This is especially true in extremely volatile markets where prices can change quickly. In such circumstances, a big temporary market move may cause a trader’s stop loss to be activated, and the market prices then reverse back in the trader’s favor. This would force the trader to exit a trade that might have turned out well.
Another risk that traders need to be aware of is the “stop loss hunting” behavior. When traders with a lot of capital manipulate the market to set off stop losses and then repurchase the assets at a loss, this happens. Market makers and institutional traders frequently employ this strategy to exploit retail traders who use stop losses.
Position sizing is the number one way to manage the size of losses even more than stop-losses. The most you can lose is your total position size, but a stop-loss does not guarantee the maximum loss, as gaps, company bankruptcies, and a lack of exit liquidity can make losses bigger than expected. Position sizing is the best risk management tool in the options, futures, and crypto markets.
Truth #3: Other traders can manipulate stop losses
The possibility of stop-loss manipulation by other traders is one of the main concerns of using stop-losses. As noted in Truth #2, traders with significant capital can manipulate the market to cause stop losses and repurchase the assets at a discount, a strategy known as “stop loss hunting.”
This danger is particularly common in thin markets with few traders and little liquidity. Even a modest amount of money can alter these markets’ prices, setting off stop-losses. Furthermore, there may be greater slippage in thin markets due to a lack of liquidity, which could result in stop losses activating at a price far different from anticipated.
Traders can utilize stop-loss tactics like the “trailing stop loss” to reduce this risk. A specific percentage or dollar amount below the market price is the setting for a trailing stop loss. The stop loss will increase when the market price moves in the trade’s favor, giving the trade breathing room while also locking in profit if the market moves against the trade. This can stop traders in risky markets from getting stopped too early. The trailing stop loss strategy enables a trader to exit a winning trade and lock in profits if there’s a big reversal on a chart caused by stop running by bigger traders.
Truth #4: Stop losses can be mentally taxing
Although stop losses are an essential part of risk management, they may also be very stressful for traders, especially if they are regularly triggered. This can be particularly difficult for traders who feel they were unfairly stopped out of a trade or who may doubt where they should have placed their stop-loss order. This can result in “revenge trading,” a phenomenon where a trader makes additional trades to compensate for their losses but loses even more money. Revenge trading is where a trader wants to quickly get back all their losses, usually on the same chart they lost money on. If proper position sizing is abandoned, all the help stop-losses gave the trader to keep their losses small is given back in a few big trades against them.
Risk management strategies like position size are one approach to lessen the psychological cost of stop losses. The process of altering the trade size according to the amount of risk a trader is comfortable with is known as position sizing. By controlling position size, traders can adopt a more sensible degree of risk and lessen the impact of any single trade on the balance of their entire account.
With the right position sizing and stop-loss placement, each trade can be reduced to just one of the next 100 trades to be executed with less emotional impact from short-term results.
A well-defined trading plan that includes stop loss placement, position sizing, and profit targets will help traders stick to the plan and prevent impulsive behavior. This is good risk management and a tactic for keeping the right trading psychology to avoid letting emotions drive decision-making.
Stop losses are a crucial risk management tool but have certain drawbacks. This post covered several stop loss realities that are not frequently acknowledged in the trading community, such as their lack of certainty, failure to avert significant losses, vulnerability to manipulation by other traders, and psychological toll they may cause.
Traders must remember that stop-losses are a tool for limiting losses rather than a guarantee against them. Stop-losses have limitations and don’t eliminate all potential risks. Traders should be aware of them and use them in conjunction with other risk management techniques like position sizing and having a clear trading strategy and edge.
Stop losses are a useful tool for limiting risk in trading, but it’s necessary to be aware of their constraints and associated risks. These facts enable traders to employ stop losses more skillfully as a component of a well-rounded trading strategy.