Are Stop Loss Orders Useless?

I’ve never really understood the question “Are Stop Loss Orders Useless?” To me, it is akin to asking if pilots on airplanes are useless? Or police and firemen? Are Seatbelts? Are locks on our doors? Is insurance?

If you answered no to any of those questions, then you know where this is going. Risk management is an essential part of our lives and all of the above examples are everyday forms of risk management. Prevention of catastrophic events is something that we never give a second thought to. However there are some among us who will try and make the case that since bad things don’t regularly happen, why do we need to spend good money to mitigate a rare event? Believe it or not, some new participants to the world of trading believe that this idiotic premise applies to the use of stop loss orders, as well.

Not having a disastrous loss in trading is the one thing that we can control. We cannot control where price goes on its journey to nowhere. Oh yes, we can “think” a stock is going up or down but we are not in control of its destiny. Good traders don’t ever “think” anyway, however when we buy or sell in the market, we do “expect” something to happen directionally based on our analysis of price. When what we expect to happen doesn’t, that’s when the use of a stop loss becomes indispensible to our well being.

A stop loss for is essential for keeping a trader’s business afloat. There is not a company in the world that would let one employee take the whole company down. Warren Buffett would never let one business in his vast holdings of companies cause the demise of Berkshire Hathaway. Why would a trader allow any one loss ruin their day, week, month or year? Mark Douglas, author of the outstanding book “Trading in the Zone” refers to the unpredictability of the markets with a simple idiom: “Anything can happen.” Indeed it can. Since we are constantly reminded that we are not in control of anything that happens in the market, except what we can lose, risk management becomes crucial to our success. If you are looking for the Holy Grail like most active market participants, it rests within this often overlooked skill set. A simple stop loss lies at the heart of that expertise.

New traders often give this reason for not using stops: “I don’t use them because I get stopped out a lot and price will then reverse and go in the direction of my original expectation.” Of course this will happen and it is human nature to selectively remember when the stop may have been the impediment to what might have been a successful trade. If you are getting stopped out a lot, proper stop placement is a skill in of itself. For a buyer or seller in defined supply and demand areas, two things need to be satisfied for a stop to be properly positioned. First, price must trade above or below the targeted zone of entry making what was expected to happen, wrong. Second, the stop itself has to be placed with enough “wiggle room” outside the zone based on the personality (volatility profile) of the product. One great tool we can use to determine how much room to give price is Average True Range.

Far from being useless, stop loss orders are on the opposite end of the spectrum. Competent use of them is the only thing that will determine whether we will ultimately succeed or fail at this wonderful game of trading and investing.

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