6 Key Facts About Stop Losses In Trading (Must Know!) – DataDrivenInvestor

Why they are a necessity for trading success

Photo by Jp Valery on Unsplash

Browsing through the pages of some of the most famous traders on Fintwit (or Financial Twitter for all the newbies), it’s clear that there has never been a topic so agreed upon yet so contested.

Stop losses are universally used by traders worth their salt but in a wide and varying degree of ways.

It begs the question, are stop-losses necessary in trading?

Yes, they absolutely are. When playing the game of speculation on probabilities of which trading of all forms boils down to, you must use stop losses to mitigate risk. Without a hard or mental stop, your trading account is at risk of what is sure to end in ruin.

But if the answer is so overwhelming, why is there such conjecture on the topic, between some of the best to do it?

Let’s dive into some of the pertinent questions and facts about stop losses, and how they are used to stop you from losing your shirt.

What type of traders use stop losses?

My research shows that all traders use stop losses in some shape or form, even if they don’t refer to them as stop losses specifically.

First, you need to separate the different categories of traders. All market operators execute trades, but not all are traders.

Each has its sub-categories, but you are mostly going to be a part of 1 of two camps:

  • Investor
  • Trader

Different types of investors might be, value, sustainable or activist investors.

Subcategories of traders would be scalpers, intraday, swing, or position traders.

All of these will have their own reasons to activate their risk management plan and exit a trade.

They are all a form of stop loss.

Investors are more likely to have what is known as a mental stop, where they will sell a stock based on a fundamental change in the intrinsic quality of the underlying business. They are less likely to let a stock price factor in the reason to exit the trade.

A trader is rather different, usually entering a trade based on a wide range of technical factors and criteria. When the market turns against them and renders their analysis incorrect, the need to exit the trade becomes hastier, as they are unfamiliar with the intrinsic quality of the underlying business.

Due to the mostly shorter duration of the trade idea, a lot of traders use hard stops or market orders, to make sure they are out of a trade at a certain price level.

This is not hard and fast for all traders though. Many scalpers use mental stops to exit trades as they are less likely to be away from the market due to most of their trades being for minutes or seconds.

The important takeaway here is that you need to have a form of risk management. Choose which of the many methods suit you and your strategy, but you simply can not afford to bypass it.

Do professional traders use stop losses?

Yes, they do, either hard or mental stops are used by professional traders of all sizes.

Some of the best traders I have learned from and still follow today preach the importance of having a stop loss and adhering to it. They include Kristjan Kullamägi, Pradeep Bonde, Stanley Druckenmiller, and even Warren Buffett!

The key to using a stop loss effectively is to understand why you are using it.

Having an arbitrary number and selling because the stock hit that number is ridiculous

Legendary trader, Stanley Druckenmiller was quizzed on this topic once and summed it up quite brilliantly.

I’ve never used the stop loss. Not once. It’s the dumbest concept I’ve ever heard. [If a stock goes down 15%] I’m automatically out.

But I’ve also never hung onto a security if the reason I bought it has changed. That’s when you need to sell.

If I buy X security for A, B, C, and D reasons and those reasons are no longer valid, [I sell].

Whether I have a loss or a gain, that stock doesn’t know whether you have a loss or a gain.

You need to have a verified setup that you have researched and tested yourself.

Once you have this, you should know why the stop loss is being placed: because your verified thesis is wrong in this case. You should know why you are right and why you are wrong on every trade.

When the reasons you entered a trade in any format or strategy change for the worse, you need to exit the trade.

Warren Buffett famously does this too, even though he is revered by some as a buy-and-hold prodigy that never sells.

The never sell crowd is for the lazy.

He states his favorite holding period is forever, but he is only committed to this with the stocks that deserve it.

When the quality of the business changes or he longer sees good future prospects, he is as ruthless as anyone in selling. No room for stragglers in the portfolio of the GOAT.

Below is a great video explaining how to place a stop loss for swing trading. the principles can be applied to all types of trading.

What happens if you don’t use a stop loss?

Quite simply, you risk losing a lot of capital.

Without some plan for the inevitable downside of some of your trades, you are basically stating that you have no risk management plan.

Under these conditions, the only way you will not blow up your account is pure luck.

Over a large enough sample size, it is certain that you will end up in ruin.

Even the very best strategies do not have a success rate of 100%.

In fact, most only have around a 40–50% win rate at best.

Prior knowledge of these probability statistics and still not employing a stop loss in some way, means you are on a trading suicide mission.

It is statistically certain to end in failure.

Can you lose money with a stop loss?

Slippage is a topic not spoken about enough in the trading world.

There are too many gurus trying to sell you perfect black box formulas where it’s all an exact science and things work out perfectly every time.

But a reality of trading is that you will not always get perfect execution on your trades from your broker.

When you are trading in markets that have lower than average liquidity, slippage can be a real problem.

Slippage refers to the difference between the expected price of a trade and the price at which the trade is executed.

So even with the best intentions and a perfectly set stop loss, you can still lose more money than you intended through slippage.

Slippage is something that needs to be considered in your trading plan.

What is the 1% rule in trading for stop losses?

The 1% rule is a guideline for stop losses which is generally acceptable for most traders.

It’s where traders only risk 1% of their total account capital, per trade.

This is considered a relatively conservative position size and risk per trade although traders use an average risk per trade ranging from 0.25% to 5% on some trades.

What level is appropriate for you will come down to your strategy and risk appetite.

There is no one size fits all approach to risk per trade, but it would usually be a function of the opportunity presented, commonly referred to as A+ setups by many traders.

Professional traders are more likely to risk more per trade on what they consider an A+ trade, as the risk is far outweighed by the potential reward on the opportunity.

This is something that should be considered when choosing your risk appetite per trade, rather than an arbitrary number.

Do stop losses work in a crash?

Unfortunately, in a full-blown market crash, the usual safety net provided by stop losses may be compromised.

In a worst-case scenario, the market can either miss your stop completely due to a lack of liquidity at that price, or the price can gap past your stop loss level.

When this happens, your stop loss either triggers at a much larger loss level or worse gets missed altogether and you end up being stuck in a trade that is deep in the red.

A stop loss is not a guarantee of your risk level on a trade.

You need to be prepared for anything when your money is in the market.

Major crashes are not common, so the risk of this is relatively low.

But the possibility of your stop loss being missed is present every single time you make a trade.

This makes it all the more important to focus on position sizing and not a) risk more than a few percent per trade and b) not have your whole account in one trade.

If you are reasonably spread out among a number of stocks, the likelihood of all of them gapping down together becomes much lower.

Just remember risk never sleeps and there are no guarantees in this game.

Final Thoughts

As you can see, stop losses play an important factor in mitigating risk no matter what role you play in the market.

They are used by professionals and retail traders alike, across many different subgenres of investors and traders.

We are also well aware that no matter what they refer to their stop loss as, no one has ever been successful in this industry without a clear and concise risk management plan that is adhered to strictly.

This further illustrates the importance of stop losses and risk management and how you should be implementing it into your trading plan in some shape or form.

Sure they are not bulletproof or guaranteed, but they are better than the alternative. Losing your whole account and your trading dream.

Choose wisely.

This article is for informational purposes only. It should not be considered Financial or Legal Advice. Not all information will be accurate. Consult a financial professional before making any major financial decisions.

Leave a Reply

Your email address will not be published. Required fields are marked *