Last updated on May 12th, 2020
One of the golden rules in trading is to protect your trading capital.
Using a stop loss in trading is a smart move to protect you when the random distribution of wins and losses play out with you on the losing end.
You can think of a stop loss as a limit order resting in the market to take you out of a trading position that is not having positive feedback in your traded direction.
When hit, the stop loss order (limit order) will be turned into a market order and will be filled at the best possible price.
Since a stop loss order when triggered turns into a market order, all the risks associated with a market order such as slippage, applies.
Stopped Out And Market Resumes
Wouldn’t it be great if every time the market hit our stop orders, it carried on moving in the same direction for a significant move?
It doesn’t and that is the reality of trading.
Markets can sometimes move to take out your stop then reverse all the way to where your profit target originally was – and this can lead to a situation where you have trouble taking your stop loss order when price is approaching.
Forex traders for example have seen that happen many times in their trading career. A well placed stop loss order gets taken out to the pip and the market reverses direction. I know that I have lived in that frustrating world a few times in my trading career.
Frustration can lead to emotional decisions and in trading, anything emotional doesn’t have a positive outcome.
A stop loss that is placed in a location that makes sense due to the volatility of the current market condition can be ticked out and the market heads to your original profit target. If this happens too often, a trader will be hesitant to take the stop out and will move their stop further away from price action.
Stop losses based on percentage of account that gives you your position size and gets moved further from price increases the overall risk you’ve applied to your trading account.
This has the potential for a bad ending.
One Trade Does Not Make A Trading Plan
It can be hard in life to look back in time at the positive events when your life is currently in shambles. In trading, it is much easier to look back at individual trades where being ticked out occurred than it is to see when you were stopped out and the market kept going.
Failing to do that will have traders not taking their stops and that is a trading error you must avoid. Traders have been known to alter their entire trading plans to compensate for an error as opposed to testing and fixing the error.
Tracking the true cost of any trading error is an enlightening exercise and it is easy to lose track of the actual difference in p/l especially when there are trades where you get away with the error. So taking the time to dig into your trade log and figure out the true cost is an important exercise.
You Will Get Stopped Out
You will get stopped out in your trades and the probability of being ticked out over many trades is great.
Let’s say that the probability of your stop getting 1-ticked before the market reverses to target is 1%. If you take on average 4 trades per day for day traders and 20 trades per week, the chance of a 1-tick stop out before the week starts is 18%.
Now that starts to be significant.
Momentum Into Your Stop Loss Location
The market can make you feel like it’s going to 1-tick your stop more often than it actually does. The way it approaches your stop can be nerve-wracking at times, but there are plenty of times when it will reverse before it actually hits it.
But that feeling can work against you when you move your planned stop before the market reaches it and then it doesn’t turn.
If you are placing your stop loss in a location that has a relationship with the reality of the market, a stop out shows a change of character in the market.
- Based on volatility
- Based on previous swings
- Placed above or below significant turning points in the market – technical analysis
If your stop is placed in a location that if broken shows a change in the market, you will not be the only one looking at that location. You may expect further flow into the market at those points and you don’t want to be on the wrong side of momentum coming into the market at your stop loss location – one that you have moved.
In the graphic, the potential resistance zone is a high valued area where previous shorts will defend their position. The risk is that traders will place a stop loss to close to the zone and get “ticked” out when the zone would hold.
Remember that these are never precise price points and that all chart patterns and structure must have a built in margin of error. My stops are generally a measure of ATR (average true range) and take into account swing points that may be close by.
In the example, a technical analysis trader shorting at the consolidation level as their trading strategy may measure the height of the consolidation pattern and then place their stop loss the same distance plus a buffer away from trade entry.
Even if you are trailing your stop loss order to be taken out of the trade with a profit, you still want to ensure your stop is in line with the context of the market. Trailing stops can add to your bottom line but they must be done according to a tested trading plan or at least in line with current volatility.
Markets Can Change
If you are regularly getting stopped out just before the market turns, it could be that there’s something in need of attention in your trading plan – keep track of your results over time and assess whether the number of times it is happening is reasonable or not.
But even if you take a few unlucky 1-tick stops over a small sample of trades, it could also be that you are experiencing a market streak.
When something happens in the world, markets can change their behavioral characteristics quickly and an increase in volatility could mean that your stop is too tight in the current environment
The behavior may not last, but it could leave an indelible mark on a trader’s psyche.
A paranoid trader not wanting to get cheated out of their money can add a large number of ticks to their losing trades – far more than the few stop-outs they save by moving their original stops.
Let Your Stop Loss Protect You
Recognition of the cost of not taking your stops is the first step to correcting the problem. The second major step is to see that over time, the chances of this happening become far greater.
Mentally rehearsing taking your stop when you are unsure of whether the trade will continue much further against you is a powerful exercise to prepare you to execute your trades as you have planned – and inevitably, sometimes the market will 1-tick your stop.