Stop Losses – Two Recent Perspectives

Mar 21, 2007: 8:49 AM CST

I wanted to highlight two recent posts concerning whether or not to use stops, and what exactly is their purpose.

From Move the Markets, Prospectus discusses “What Is a Stop Loss For Anyway?” The premise is that many investors make an error by placing a stop at the point where “the market will prove your opinion wrong” and waiting for that spot to be triggered before exiting the position. A quote:

“It wasn’t the stop that proved me wrong, it was the price action immediately after my entry that clearly said that my position was wrong.”

He then describes proper usages of stops as “damage protection” or maximum loss per trade, with implications on position sizing.

He comments on how you must use stops, yet if the trade you enter does not work in your favor immediately (meaning the trade must prove itself right), then you should exit before the market declines to hit your stop. By doing this, you keep your losses very low and don’t wait for the market to drift down to your stop and cause you a larger loss – losses can be limited by exiting before your stop is hit if price does not perform in your direction immediately.

Read the article and check out the comment section on the site. A few of the comments from the other side include:

“I don’t think people should look for any excuse to exit a trade, just because the price is below their long entry. After all, they hopefully picked a stop that would be below the leeway they are willing to give the stock within their setup.” -Richard

“I’ve realized that I was moving my stop way too soon. Sure, there were trades where I’d save 0.5R or maybe a little more by doing it, but I missed out on over 10R worth of profit by moving my stop too soon.” -Dave

A second recent article from Trade 4 Cash blog entitled “Stop Losses, Should You Use Them?” took the opposing view, and questioned whether you should use stop-losses at all! The author tested various stop-loss methods and posted the results, which were quite shocking, but logical.

A quote from the site:

“There are disadvantages of using stop-loss orders, however. Many times a stop-loss order will force the trader to sell a stock during a normal correction, especially if the stop price is set to close to the original purchase price. A stock needs room to move during the course of a day/week/month, and stop orders that are set too tight will result in several premature sells, negatively affecting overall performance.”

In summarizing the results:

“The question of whether or not to use stop-loss orders is one to be answered by each individual trader.” Some systems benefit (statistically) from stops while others do not – it depends on the trader and the system.

In general, stop-loss orders will

1. Reduce the success percentage (% correct)
2. Increase the turnover rate (increasing commissions)
3. Decrease the average drawdown per trade”

These are serious topics and so many perspectives on this issue. I have heard that “Trading is a game of who can take the most heat,” which means that those that succeed in the long run are those who can take on the pressures of a position going agaisnt them (withing selling immediately) while others capitulate.

In my experience, I have entered or seen clear buy signals, taken them (or observed them), placed my stops “properly” (below a key techincal area “beyond noise”), seen my “proper” stop be taken out and I move on, only to look back and the trade violently moved in the proper direction after the “stops were taken out.” This has happened far too many times to be coincidence, and I will be addressing this further.

I do want to encourage readers to think about stop loss placement and usage, and not just go by “textbook explanations” – your goal is either to place your stop beyond where everyone else is placing it, or (aggressively) try to enter like a professional at points where stops appear to be taken out, just before the expected rally.

It ultimately depends on your system and your risk preference, and the only way to learn is to gather your own data and analyze various stop-loss methods. Question conventional wisdom and see what works for you.

6 Comments

6 Responses to “Stop Losses – Two Recent Perspectives”

  1. Richard Says:

    It’s important to note that the trade4cash guy only commits a very small % of his account to any one trade, which is what makes his stance on stops viable. He could ride any one stock down to 0.00 (not that he would actually do that) and not hurt too badly. In contrast, any small daytrader that’s committing most of his or her account to each trade could be put out of business without some reasonable “uncle” point.

  2. humble1 Says:

    Great site. You should look at Van Tharp’s work on stops. It is an eye opener. Also, most traders have no way of confirming tops and bottoms properly and will place stops in the wrong place to begin with.

  3. ArizonaChartist Says:

    Is there any way for a retail trader to either know or guess with a reasonable probability of being correct where there are a large number of stops set?

  4. Brian Schumacher Says:

    Corey,

    I just recently learned of your site, and was surprised to see a reference to my article at Trade 4 Cash regarding the use of stop losses. Richard is absolutely right – I only devote 1/12th (8.3%) of my total capital to any one trade. So if the stock ceased to exist, I would only take an 8.3% hit to my account.

    The use of stop losses is a decision that each trader must make for himself. There are good points to be made on each side.

    BTW I like your site, and will be adding it to my blogroll in the next day or two. Keep up the good work!

  5. Corey Says:

    Brian,

    Thank you for your comment and excellent blog. I have gleaned valuable insights from your weekly post series and am looking forward to more!

    Thank you for the clarification as to your stop-placement method. I was unaware until Richard pointed this out to me and it makes sense. Your point is also valid, as is your research, of course, regarding not using stop-losses as hard rules (or at all). It’s hard to argue the data and conclusion you found and I wanted to give your thoughts credence to the readers and contrast it with Richard’s notion of taking a stop before the market hits it.

    I’ve fought and struggled with stop-loss placement and have tried volatility stops, technical analysis stops, range stops, but have never tried “no” stops and I think the point is at least worth considering.

    Thank you for the compliments and I look forward to hearing and reading more from you!

  6. Brian Schumacher Says:

    Corey,

    I just recently learned of your site, and was surprised to see a reference to my article at Trade 4 Cash regarding the use of stop losses. Richard is absolutely right – I only devote 1/12th (8.3%) of my total capital to any one trade. So if the stock ceased to exist, I would only take an 8.3% hit to my account.

    The use of stop losses is a decision that each trader must make for himself. There are good points to be made on each side.

    BTW I like your site, and will be adding it to my blogroll in the next day or two. Keep up the good work!