Stop Loss

The Trade Management Tool of Necessity

Most traders have heard of the stop loss.  It's right there on the order screen and tough to miss.  But using it is an option for each trade and, when you think you're right about a trade, then you also think "who needs it?". 

The fact is that every trade is not going to go exactly as you had planned.  We can be 99% certain about a trade and then watch it fall apart right in front of us.  And, since we're watching the unexpected occur, we're caught like a deer in headlights, trying to figure out what to do next. 

Here's a hint:  this is not the time for thinking.  The thinking and planning should have gone into the trade decision on the front end.  With each trade, you need to ask yourself this important question "What will the chart look like if I'm wrong?"

For example, let's say you went long on GOOG inside the yellow circle on the following chart:

Your expectation is shown by the green arrow.  You think price is going to go higher from that point and that is why you are long.  But part of the trade decision and the position sizing is determined by looking at a recent area of support.  In this case, you might look at the last area of price support at the red line and determine that would be your stop. 

Knowing the red line of your stop loss helps you in several ways.  First, you have predetermined your stop on the trade.  This gives you more confidence because you have spent time looking at the charts.  Second, your stop then becomes the basis for your equity position.  I call this "risk-based equity positioning" and it simply means that your stop tells you your risk and this determines how much equity you are willing to lose on the trade in a worst case scenario.  Knowing this ahead of time allows you to psychologically handle the retracements that often occur on a chart while price zig-zags across the chart.

The Stop Loss Determines the Equity Position

Now, let's think about what most traders do in the real world.  Most traders do not determine the stop first.  They do this because they are over-confident about their ability to predict future price movement.  It is the gambler that lives inside each of us.  We love the adrenaline rush of trading and thinking about possible negative outcomes doesn't jibe with that!

So, what happens next is critical.  If the trade moves against us, we typically add to the losing position as a sort of "averaging down".  We do this because we still think we're right and we're slow to accept the idea that we could be wrong.  We do this because we hate to lose money.  We do this because it's the only way to keep the positive adrenaline pushing through our veins!  We add to the trade.

And then an even worse thing happens:  sometimes it works out!  That's right, sometimes we get lucky and our combination of trade entries works out so that we make a profit or at least get out at break-even.  And the reason this is bad is because those are the instances we remember.  Our mind blocks out the many times it did not work out and we hold a trade for an even larger loss or it crashes our account (again).  We only remember the few times of averaging down success and so we repeat the same mistake again the next time it happens.  The luck of the few empowers the lack of discipline on the many.

The purpose of this article is simply to get you thinking about the importance of using a stop loss on each trade.  There's a lot we could talk about on this topic, but this will get you started.

If you haven't already watched my FREE 6-part video series on Support and Resistance, then CLICK HERE.  This free series might help you become better at setting your own stop losses.