Conventional wisdom has it that stop losses are an essential part of any trader’s risk management strategy. However, the case for placing stop losses is not as clear as it might seem. While it may be good to use stop losses, there are some pros and cons that we should think about as traders.
Stop losses limit risk
The idea behind a stop loss is very simple. If your position goes too far in the wrong direction, then a stop loss will generally guarantee that your position is closed once your losses hit a specific amount. This is critical if you’re not monitoring prices minute by minute – the stop loss executes automatically once your investment hits a pre-determined loss level.
Avoiding emotional decisions
Aside from the automatic nature of a stop loss, a stop loss can also help you avoid making decisions that go against your overall trading strategy. When a position leads to losses, it’s very tempting to chase the loser by averaging down or hanging on until the price recovers. However, trends are powerful movers in markets, so giving into your emotions and trying to recover your losses is generally a bad idea. Placing a stop loss will help you avoid this.
On the other hand, stop losses may turn a winning investment into a losing one. If you place your stop loss too close to the strike price for the trade, then there is a good chance that normal volatility in the market will cause the stop loss order to trigger before you make your profits. This can even happen if you are right about the way that the price is going to move in the medium term. Generally, you will probably want to place stop losses at levels where short-term fluctuations are unlikely to trigger the order. That’s why it may be important to use indicators to measure market volatility when you’re placing your stop losses.
Also, your stop loss placement depends on your style of trading. For example, if you’re a short-term trader, then you might want to place your stop losses so that you limit your potential downside to a few percent. On the other hand, if you’re a long-term trader, then you might want to place your stop losses more widely.
Holding positions overnight
One of the arguments against stop losses is that the price may gap down or up overnight, and therefore your stop loss will protect you. However, you can also get a guaranteed stop loss – which means that if the market gaps overnight, then your risk is limited. This will cost you a bit more when you trade, but it can definitely be worth it under volatile market conditions. And the good news is that some brokers offer guaranteed stops automatically whenever you make a trade. This means you can be sure exactly what your risk is at all times.
Do stop losses hurt?
While stop losses are an effective risk management strategy, there is evidence that they may have a negative impact. In fact, one analysis showed that overall trading performance was hurt by any stop loss placement – even if that stop loss was as far as 50% away from the opening price. So if you have good emotional control and can keep an eye on your positions in real time, then stop losses may not be for you. However, if you’re a mere mortal like most of us, then it may be better to stick with stop losses and manage your risk.
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