The Stock Market is unique and full of uncertainty. In real-time the markets are complex, but after the fact everything looks simple. It’s this dichotomy that tricks many into thinking that there is easy money in the stock market. But it’s not.
As an investor or a trader you can hope that a stock to go up or down, but you can’t control it. Stock market is a collective reflection of thousands and millions of participants and no single entity has any control over it.
You are dealing with geopolitical, environmental, financial, technical, human and many other uncontrollable factors every single day. Controlling the downside (loss) is the only control you have to address numerous challenges everyday.
Why use Stop Loss?
Here are basic steps that you have control over in the stock market:
- Which stock to buy?
- When to buy and quantity?
- What price?
- When to sell?
Mostly people can answer the first questions with some confidence. It’s the “when to sell” that’s hardest in the stock market. If the stock has moved in your desired direction then selling is somewhat easy.
So, lets focus on when the stock has moved in the opposite direction and there is a loss. Many of us are reluctant to sell and close the position when there is a loss. Even if it’s is a small loss, it’s against the human nature to accept defeat.
Often times a small loss turns into a major setback – both emotionally and financially.
A stop loss strategy addresses this problem. When you buy a stock knowing how much you want to risk, you have accepted the consequences. You can place a stop loss order and take control of your stock position.
Winners use Stop Loss.
Risk Management with Stop Loss
The deeper the losses the longer it takes recover to get back to break-even.
Let’s say you have a $100 stock and you sell it at 5% loss ($5). Now you are left with $95 capital.
If you recover just 5% on your next trade you are at an overall loss i.e. $95*5% = $99.75.
Therefore, you will need to recover 5.26% to break-even i.e. $95*5.26% = $100.
|Loss||Recover to break-even|
The table above highlights the effort required to break-even. To stop the situation from getting out of control, it’s important that you enter stop order as soon as the stock position is filled. Think of this stop order as an insurance to protect you in case the trade goes against you.
If your stop loss order is triggered:
- You are protected from deeper losses
- You now have the capital available for other trades.
Types of Stop Loss orders
Examples of Stop Loss Charts
Charts showing how a stop loss order prevented larger losses.
Happy New Year!
Stop Loss. Two words but THE most important words in trading. Your breakdown in the table to show that profits are required in the next trade to break-even overall is simple yet powerful. I’ve derailed from my plan and moved and cancelled stops on several orders to learn the lesson VERY hard way. Nicely laid out in the article above.
BTW, sometimes your stop range in the alerts is little tight. I usually give some room for the trade to work and let it hit the stop if it wants to.
Stop Loss is good in theory but hard to use on live trades. I have no problem using it on paper money account but when it comes to actual trading account, I frequently move stops or don’t use it at all.
Anybody else in same boat?
There is a reason some major exchanges are getting rid of stops. Large HFT firms (and others) can read your stops from a mile away and act on them accordingly when they are given information in exchange for order flow.. PayForOrderFlow..
Thanks for the insights. HFT algorithms and others running through the Stops and shooting right back up/down is something we’ve seen many a times. But it’s imperative to ensure that a stock position does not cause a big drawdown or whip out an account. A trader should always use some mechanism to limit losses. Some use Mental Stops for the very reason you mentioned above.
I read somewhere that NYSE and NASDAQ is eliminating stops orders soon.
Thank you for the comment. You must be referring to this article.
However, stop orders play critical role in current trading systems at several large institutions and at retail level. Brokerage firms will continue to offer it one way or another… they already do it through their systems. Has anyone heard from their broker about this upcoming change from the exchanges?
Some brokers like TDAmeritrade provide trigger order types that automatically submits stop and profit target orders once the position is filled. If the profit target is reached, the stop order is cancelled and vice versa.
Thank you for the information. Brokerage firms offer different order types as added service to their customers like the one you mentioned above. There is also trailing stops which is very useful when you are not in front of the computer all the time. For a long trade it continuously trails the stop price higher as the stock keeps moving in your intended direction. Similarly it’s the opposite for short trade.