A stop loss is not only one of the most important things a trader has
to have, but executing it the right way and understanding what a stop
loss actually is, is critical for trading success. Misunderstanding the
logic behind a stop loss order will be disastrous for a trader.
Revenge-trading and moving stop loss orders further away when price goes
against you are just two of the trading mistakes triggered by a wrong
belief about stops. Those mistakes are often the cause of significant
losses for amateur traders and the reason why it is important to take a
closer look at the logic and nature of stop loss orders.
The one and only thing that a stop loss order really should be
This is the cause of all problems with stop loss orders. A stop loss
order should be placed at a price level where it cancels your trade idea
and where your anticipated trade scenario is invalid. This is the one
and only reason behind a stop loss order. However, most traders follow a
wrong and dangerous process. First, amateurs identify a trade entry,
then they look for a potential profit and finally they choose a random
stop loss level that allows them to trade with a decent reward:risk
ratio and enables them to potentially achieve a certain profit. This
could not be more wrong because it shows a complete misunderstanding of
the nature of stops. A stop loss order should be placed at a
price level where it cancels your trade idea and where your anticipated
trade scenario is invalid. Not at random price levels that enable a
certain profit. The optimal process of placing a stop loss order The wrong approach that most traders follow when it comes to stop loss placement
A trading scenarios and stop loss placement
First, a trader should have a trade idea in his mind and in his
trading plan. Then he looks for a price level that would cancel his
trade idea. For example, if you want to enter a long trade after a
bounce off a double bottom, you have to define how much room you are
allowing price to penetrate the double bottom. Below this point, you set
your stop loss because it would cancel your trade idea. The screenshot
below illustrates the scenario. The green shaded area represents how
much you allow price to go against your trade and where you still
believe that your trade idea is correct. When price enters the red area,
it has moved too far and a buy trade is not the right option anymore
because it signals that a bounce off the support and previous low is not
a reasonable assumption. Stop Loss – Valid vs. Invalid trade idea – click to enlarge
Nobody cares about your entry
This point is a continuation of the previous statement. The reason
why traders believe that their trade idea is still valid, even if price
exceeds their stop loss level is because they overestimate the
importance of their entry price. Just because traders don’t want to
realize a loss, they hope that price will turn around and go back to
their entry. At this point, they are trading completely based on hope
and emotions and have completely forgotten about their original trade
plan. If your original trade plan was to buy a bounce off support at a
previous low, then you should never forget your plan! Never! A price
that goes too much against you, signals that your idea is not working
out and that support is not holding. If price eventually turns, it has nothing to do with your idea or price support anymore and you should be out by then.
What moving a stop loss means
A common mistake is that traders move stop loss orders further away
once price moves against them. However, this means that now price has to
move even further so that you can make a profit. Looking at a trade
that is going against you from this perspective often makes it much
clearer why moving a stop loss further away is such a bad idea. Not only
can you now realize a much greater loss, but your trade now has to move
much further in order to make any money. The screenshot below
illustrates the concept. The trader initially bought at previous support
and anticipated a bounce and a price move higher from there. The
initial stop loss (1) signaled where his long trade idea would have been
invalid. Remind yourself, when price reached his stop loss level, it
would have signaled that he does not expect price to go to his take
profit order anymore. However, he decided to widen his stop loss order
(2). Now, once price keeps going down, the distance between current
price and the take profit order increases significantly and although his
original trade idea was bullish, the overall chart looks very bearish
and a price move all the way to the take profit order is very unlikely
and not in line with his original trade idea. The idea is that when price reaches your stop loss level, you don’t expect it to go to your take profit order anymore.
Staying in a trade that goes beyond your stop is not based on sound
trading principles and a trading plan. Always keep this in mind when
engaging with your stop loss order. Stop Loss Widening – What it means for your trade – click to enlarge
Ask yourself the following question before moving a stop loss order: If you were not in the trade already, would you do it all over again with a stop loss at the price you are about to set it to?
Most of the time, the answer is no and you are better off by closing
the trade and re-evaluating the scenario. Being in a trade often clouds
our decision-making process because we are emotionally attached to the
trade. Try to avoid such scenarios and always stick to your stop loss
order.
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