QUESTION:
I have heard that professional traders don’t use stop losses. Why then is it that everywhere I look, the advice given to traders is “don’t trade without stop losses”?
ANSWER:
To dig out the reasons behind why almost everyone recommends to trade with “hard” stop losses, we can start by asking ourselves what a hard stop loss trade really is. It means that your broker has to at least try to get you out at a certain price that you have determined, and so although there can be some slippage, you are defining and limiting your risk. This is the first reason right away: if you are not defining your risk on each trade, things can become psychologically difficult very quickly. Consider also that should there be some kind of terrorist attack, environmental or nuclear catastrophe, or even just loss of internet or power, if you do not have a hard stop loss in place you could end up losing much, much more than you bargained for, possibly even endangering your entire account.
Many new traders come to hate the hard stop loss trade as very often, after they are stopped out of a trade, the price soon comes back to a point where the trade could have exited with a profit. They wonder why they took a loss when if they had just hung on they could have made a profit. Then one day, the price never comes back after hitting the stop loss, but just keeps going against them for 1,000 pips, and they discover why it was a good idea to have that stop loss after all!
A good example of another group of people who were trading without a stop loss and who ended up wishing they had used one were the traders long of the Swiss Franc when the Swiss National Bank effectively announced a massive devaluation. The price flew against them for several minutes and hundreds of pips without stopping.
What it really comes down to is, are you ever prepared to take a loss? If the answer is yes, and you are not using hard stop losses, then you not only taking a risk against unexpected events, but you are also going to have to be able to exit losing trades manually without letting blind hope make you hang on too long. That is very tough psychologically, even for experienced traders.
If the answer is no, you will never take a loss, then you are presumably doubling down on the trade hoping it will average out, or maybe entering a larger “rescue” trade in the same or even opposite direction. There are some professional traders that do this, but it is a very dangerous game. This is why every so often you hear about some “rogue trader” who instead of taking a loss kept doubling down until they completely bankrupted the bank!
The main reasons you should always use a hard stop loss are as follows:
- Protection from huge losses should an unexpected catastrophic event occur.
- Peace of mind from knowing your risk is defined.
- Makes it possible to walk away from a trade.
- Avoids the psychological pitfalls of being forced to decide, possibly under stressful market conditions, when to crystallize a loss.
Don’t confuse problems arising from poor stop loss placement with the use of a stop loss trade at all. You should always place a stop loss at a point where if the price gets there, you would feel wrong about the trade. Bear in mind that sometimes other traders are going to try to drive the prices to obvious areas where stop losses are, so you might want to consider placing your stops just a little bit further away. Having said that, if you review historical data, you will find that many of the very best trades take off straight away after the obvious entry, and pull back only a little bit or not at all, but that is a topic for another time.
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