Why a small stop loss will hurt you! What you should do
Hello traders! I am sure when you started out in trading, you heard the saying "cut losses short and let profits run" from other traders. Yes, that is correct, but it lacks something important. What is exactly a stop loss? How big should it be? Least probably you asked these questions when you read them.
If you don't know what a stop loss is, it is a price line as to when the prices hit it, you "cut" your losses by exiting your position. Here is an example:
Unfortunately, many traders interpret it as that a loss should be cut short immediately, and that the stop loss should be small in relevance to the target price. The traders now translate this to having a small stop loss to minimize loss. Seems right at first glance, but it is not. Why is it wrong? I can give you reasons you should avoid small stop losses:
1. Fails to take into account market volatility
Let us take Stock X. Let's say this Stock X trades from $10 to $11. If you put your stop at $10.9 for example, it is very likely your stop loss will get hit by useless market noise and even the spread of the bid and ask! Oops!
2. Overwhelmingly high losses
Thinking that a small stop loss gives you small losses? Simply wrong logic. Because your small stop loss gets hit every time, you lose money every time. The losses accumulate, therefore, become very high.
3. Psychology of the trader will be in a bad state
How do you feel when you lose 10 times in a row in trading? You feel irritated and sad, right? Of course! That is what happens when the number 2 reason takes place. Your trust in your trading system will plummet and irritate you. The irritation will affect your trading, therefore making your trades gut-based and emotion-based, a mortal sin of trading. Then you lose money.
These reasons may give you enough evidence to still avoid small stop loss. But I bet, there are still many of you who strongly disagree, including trading "experts". But, I will give solid proof as to why.
I used a backtest site called StockbackTest (which by the way is not a recommendation to use) to backtest a simple system that Shorts when the MA200 crosses above the price, and Longs when the MA200 crosses below the price. I will be showing the results of this simple system(which by the way is not a recommendation also) on AAPL 2 times from 2005 to 2015, with a profit take if profits are 10%, but the only difference is the stop loss is 0.2% and 5%. Check below:
0.2% Stop loss
48.1% win rate
16.1% return
5% stop loss
52.4% win rate
58.2% return
Yikes! The 0.2% stop loss gave only 16.1% returns, very small compared to the 58.2% return of the 5% stop loss. This is not the only proof. Many famous traders like Jacob Bernstein also has performed backtests on small stop loss vs large stop loss.
Here is a visual scenario of a small stop setup:
Speaking about stop losses, how much should be your stop loss? Here are some basic guidelines:
1. It should be based on the volatility of the market
Let's take an example: Futures X trades at $93 - $95. An appropriate stop loss would be at around $91.5, because you wouldn't be stopped out so easily, giving room for profits. Refer to the diagram below
2. Historical Price Support/Resistance
A stop loss is more likely to do its job properly if we base it on support/resistance. The support/resistance can be a trendline, a Moving average, etc. Refer to the diagram below
One last thing: Stop loss is not the only thing you need to know. You also need to you entry points, indicators, etc.
Thank you for reading this lesson about stop losses! Make sure to like, follow for more. Thank you!
:D :} :) :]
If you don't know what a stop loss is, it is a price line as to when the prices hit it, you "cut" your losses by exiting your position. Here is an example:
Unfortunately, many traders interpret it as that a loss should be cut short immediately, and that the stop loss should be small in relevance to the target price. The traders now translate this to having a small stop loss to minimize loss. Seems right at first glance, but it is not. Why is it wrong? I can give you reasons you should avoid small stop losses:
1. Fails to take into account market volatility
Let us take Stock X. Let's say this Stock X trades from $10 to $11. If you put your stop at $10.9 for example, it is very likely your stop loss will get hit by useless market noise and even the spread of the bid and ask! Oops!
2. Overwhelmingly high losses
Thinking that a small stop loss gives you small losses? Simply wrong logic. Because your small stop loss gets hit every time, you lose money every time. The losses accumulate, therefore, become very high.
3. Psychology of the trader will be in a bad state
How do you feel when you lose 10 times in a row in trading? You feel irritated and sad, right? Of course! That is what happens when the number 2 reason takes place. Your trust in your trading system will plummet and irritate you. The irritation will affect your trading, therefore making your trades gut-based and emotion-based, a mortal sin of trading. Then you lose money.
These reasons may give you enough evidence to still avoid small stop loss. But I bet, there are still many of you who strongly disagree, including trading "experts". But, I will give solid proof as to why.
I used a backtest site called StockbackTest (which by the way is not a recommendation to use) to backtest a simple system that Shorts when the MA200 crosses above the price, and Longs when the MA200 crosses below the price. I will be showing the results of this simple system(which by the way is not a recommendation also) on AAPL 2 times from 2005 to 2015, with a profit take if profits are 10%, but the only difference is the stop loss is 0.2% and 5%. Check below:
0.2% Stop loss
48.1% win rate
16.1% return
5% stop loss
52.4% win rate
58.2% return
Yikes! The 0.2% stop loss gave only 16.1% returns, very small compared to the 58.2% return of the 5% stop loss. This is not the only proof. Many famous traders like Jacob Bernstein also has performed backtests on small stop loss vs large stop loss.
Here is a visual scenario of a small stop setup:
Speaking about stop losses, how much should be your stop loss? Here are some basic guidelines:
1. It should be based on the volatility of the market
Let's take an example: Futures X trades at $93 - $95. An appropriate stop loss would be at around $91.5, because you wouldn't be stopped out so easily, giving room for profits. Refer to the diagram below
2. Historical Price Support/Resistance
A stop loss is more likely to do its job properly if we base it on support/resistance. The support/resistance can be a trendline, a Moving average, etc. Refer to the diagram below
One last thing: Stop loss is not the only thing you need to know. You also need to you entry points, indicators, etc.
Thank you for reading this lesson about stop losses! Make sure to like, follow for more. Thank you!
:D :} :) :]
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