Why bother using a Stop-Loss?

The real key to this I reveal in my Money Manual (yet to be produced, but working on) but the real reason to employ a stop-loss strategy is to get you out of a position when it’s obviously not going as planned.

Answer this question:

  • Do you possess the power, skill and knowledge so that 100% of your trades always make you money?

If you can honestly answer yes to that question then you don’t need to use a stop-loss.  If you’re only 99% right on trades then I’m afraid you need to use stops, along with all the others that aren’t 100% successful.

Think about this scenario – You have no set of rules for buying or selling, you just do it based on gut feeling – You manage to buy the dead high of a market with half of your available funds, from that point onwards the market slides downwards.  At what point do you get out?  How do you know that what is happening now is not the start of a 5 year bear move?  How do you know that the reaction is nothing but a tempory reaction and new highs will follow – at what level do you place a stop?  If this is a new bear market are you going to ride it out?

It’s that simple.

What is a Stop-Loss

I like to think of them as a level at which if hit, my analysis of the market I’m trading was simply wrong.  It’s the point at which I exit a live trade if the market touches a certain level.

Obviously a stop is an order to exit a trade, whereby you place it at a certain level – the level is subjective and open to amendment!  That’s bad for most traders as they can keep moving the stop to suit their revised analysis on a market once in a trade.

If there’s one key bit of information I can share with you it’s this:  If you enter a market based on  an objective set of rules, then you should exit the market based on the same set of rules, at target levels or by way of the market hitting your stop.

 Can you trade without a stop?

Of course you can, it’s not advisable, but it’s not my money your trading with, so it’s up to you whether you use a stop-loss or not.

I can tell you all the great traders have used stops and the reason they’ve used them is because even they couldn’t predict market direction 100% of the time – so what makes those traders who don’t use a stop so special & great?  The word to use is actually inexperienced.

Even the great W.D. Gann used stop-loss orders on his trades, he was 89-92% correct on his trades, but the other 8-11% of the time he was stopped out – if he didn’t have a stop in place the loss could have festered and grown from a small loss to a medium sized one and then to a large one!

Think about this, if you can’t be 100% right all of the time what do you need to do with your losing trades?  That’s right you need to get out of them fast and keep them as small as possible – all you have to do now is work out a plan and rules to do that.

Add them to your trading plan (you do have one right?, if not you need one) and then stick to them – religiously.

When I first started trading I did not have a clue about stop losses, I quickly learned though, through a string of bad trades that I kept hold of too long, meaning the £ loss kept growing and growing.

With today’s technology it is possible to set preferred trading rules into your trading platform and everytime you enter a trade a stop is automatically placed according to pre-set rules – this obviosuly depends upon your trading technique and style – remember there are hundreds of different ways to trade, each one has it’s own definable set of rules.

Exceptions:

Now if you’re just trading options or covered warrants then you don’t really need to worry about a stop as you should only buy the option/covered warrant for the value that you are happy to lose if it expires worthless.

I currently trade Covered Warrants for my Pension fund and once bought I don’t have to worry about a stop, I just monitor the position and sell out when my target levels are reached.

Please note that Covered Warrants and Options are not that simple and have a lot of detail within – it would be prudent to learn and understand them and how they work before trading.

Okay, so we’ve decided that stops are important and to be used.  This very act now forces you to think differently about a potential trade, it now forces you to accept a £/$ monetary loss amount per trade – you need to decide what amount of loss you are comfortable taking if you’re wrong on a trade.  How much is that in terms of £/$’s AND also % of your trading account?

Can you stomach a 0.5% / 1%/ 2%/ 3%/ 5% / 10% / 15%/ 20%+ loss – how many trades will that loss let you be wrong before you drain your entire trading account?

If you’re playing at the trading game you’ll not bother answering or thinking about this, but if you are deadly seriously of making a success from trading then it’s one of the most important thought processes and decisions you’ll make.

Now I understand and acknowledge that as soon as a stop-loss is in place you are setting the point where your research is wrong or the point of maximum financial pain you are prepared to take for that one trade.  If you trade as I do with ultra tight stops then you have to be happy to have some hit every now and again – but with my style of trading I am calling for bottoms, tops & resistance/support zones in the market, that style of trading cannot be done on guess work.

If you do try to call tops and bottoms on guesswork then you are gambling – gambling usually results in losses – think carefully!

I hope you enjoyed this post and hopefully it’s helped you to think about stops deeper.

Happy Trading

The HOVIS Trader

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