Why You Should Use the Stop Loss Order
Believe it or not, the stop loss order is one of the hardest to execute for traders. Particularly when it comes to new traders. No, it’s not technically any harder to implement than a limit or market order. But mentally, a stop loss can be hard to use because it means losses.
This may seem counterintuitive and in reality, it is. Not every trade we enter will turn out a winner. It’s simple probability. Even if we win an unrealistic 80% of the time, we still need to responsibly manage that other 20%. Failure to manage the latter correctly can cause catastrophic losses for our account. In fact, some traders have even more losers than winners. But because they manage the losses so well, they still come out ahead.
Those who struggle know they need stop loss orders. Just in the way that we know we should eat well, work out and read more. But just because we know that, doesn’t mean we do any of those three enough.
The Stop Loss
When we place a limit order, we’re telling our broker, “you need to get me this price or better.” If we’re buying a stock with a limit order of $100, that trade will not execute unless the broker can do so at $100 or better. In a nutshell, it’s the minimum price we’re willing to do on the trade. So how does the stop loss order work?
Say ABC stock is trading at $102 and we are long the stock. We want to limit our losses to $2 per share. To do so, we can enter a stop loss order at $100. So how does the trade work? If ABC touches $100, the stop loss order will trigger and a market order to sell our shares of ABC will be sent.
Now the language of that sentence is important. When the stop loss order is triggered, a market order will be sent. As you know, a market order is executed at the best price available. There are pros and cons to stop losses, which we’ll discuss in a second. But at least you know how the order is formatted.
Stop loss triggered = market sell order initiated.
Why We Use a Stop Loss
A small loss can easily snowball into a massive loss when we fail to pull the plug. When this happens, it can decimate our performance and wipe out multiple winners. Even if we have eight winning trades to two losing trades, those gains could easily be erased if we let those two losers post massive losses.
It’s part of what makes trading so hard. A big part of taking those losses is an emotional battle. Traders have a hard time separating with a loser and an easier time taking profits. It sounds backwards, but it’s true. They’ll cut winners short in order to secure profits while letting losers run in hopes their misfortunate trade will reverse.
In reality, it’s the opposite of what we’re supposed to do: Let winners run and cut losers early.
So in an effort to limit losses, traders use stop loss orders. Don’t think of stop losses as a cruel aspect to trading. Think of it as a crucial asset to saving your inventory. Trading is like running a business. Run out of inventory (trading capital) and business is over.
In this case, say you’re a grocer and you have a bad batch of strawberries. Those who don’t use a stop loss run the risk of that bad batch spreading to other batches. It leads to more waste and ultimately, less inventory. Those who do use a stop loss though, throw those bad strawberries out and thus, have more inventory for future use.
The Downfalls of a Stop Loss
Stop loss orders have their pitfalls too. During flash crashes in the stock market, there is a severe lack of liquidity. That means when a stock is in free-fall, a stop loss can work against you in that, once it’s triggered it sends a market sell order. That market order may not execute at a very good price. The same thing can happen when the liquidity is low in the options market.
Further, a stop loss doesn’t use discrepancy. Say shares of XYZ gap down from $100 to $80 because of bad earnings results. If we have a stop loss order at $95, the order doesn’t care why the stock is gapping down. It won’t ask us if we want to re-evaluate. It will trigger because the price is below $95 and it will send a market sell order. In this case, it will execute the order at $80, which is not good.
Instead, we can use what’s called a stop limit order. In this case, we get the benefits of a stop loss order, but also the benefits of a limit order. Let’s use the XYZ example again.
The stock gaps down from $100 to $80 on bad earnings. However, we have a stop limit order of $95 / $92. This means that our stop loss will still be triggered at $95. But rather than sending a market order, it will send a limit order of $92. Meaning that our broker won’t sell our position unless the price is greater than or equal to $92.
Maybe shares rebound to this level and maybe they don’t. But at least we have some say in what to do next, rather than automatically selling out at a 20% loss.
The Bottom Line
A stop loss is not a one-size-fits-all. It doesn’t work in every scenario and its mechanics are imperfect when it comes to limiting losses. There doesn’t need to be a gap-down in order to trigger an order that results in massive losses. A simple lack of liquidity and high volatility can trigger an order that’s only temporarily unfavorable.
It doesn’t have to be Black Monday of 1987 to happen either. Just look at some of the flash crashes over the past few years, the Brexit vote or the recent U.S. presidential election. All resulted in very temporary, albeit large selloffs, that didn’t last but a few hours. In some cases, not even one hour.
Nightmare scenario aside, investors can always use stop limit orders to prevent this. Further, the concept behind a stop loss is very, very important. In order to beat the market, traders need to keep their losses from getting out of hand. Stop losses are a big help in that mental fight.
Also something to note: Stop loss orders only execute during regular trading hours. It will not trigger in after hours trading.