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Last Updated on 11 September, 2023 by Samuelsson
One of the most important aspects of trading is that of managing and preserving your capital. If you lose all of your trading capital, there is no way you can make back the lost amount, regardless of how profitable your strategy is.
In order to protect themselves from outsize losing trades, many traders choose to use a stop loss. After all, it is generally touted as a necessary aspect of any trading style. But do stop losses always work?
No, stop losses do not always work. Although they manage to prevent big losses in normal market conditions, they are by no means bulletproof. Some examples of when setting a stop loss will not help at all, include market lockdowns, extremely low liquidity, and when the market gaps against you.
In this article, we are going to have a closer look at the caveats of stop losses. We are also going to look closer at the conditions that will render them less useful, or even useless. In addition, we are going to look closer at some ways you go about to protect your trading capital, without including stop losses at all.
Let’s start by looking at the purpose of stop losses before we head on towards their limitations!
Why Use a Stop Loss?
The main purpose of a stop loss is to ensure that losses won’t grow too big. While this might sound obvious, there is a little more to this than you might think right from the beginning.
Let’s use an example to illustrate this.
Imagine two traders who trade the same trading strategy with the only difference being their position size. As such, trader 1 will use a stop loss that’s equal to 10% of the total account balance, while trader 2 will use a stop equal to 2% of his account balance.
Both use a trading strategy where the only possible outcome is a loss or a profit. In other words, the strategy uses a profit target together with a stop loss to exit the trade.
Now imagine that both traders hit a losing streak of 10 trades. While trader 2 who only risked 2% per trade will be left with a 20% drawdown, trader 1 will have completely wiped out his account!
However, even with far smaller drawdowns than 100%, you might have had a loss so big that you are beyond recovery. For instance, making a 50% loss would require a whopping 100% in returns just to be back at breakeven.
While this could be perfectly manageable, you’ll quickly notice how the returns needed to breakeven grow considerably as you start to get into the 50-70% drawdown range. At a certain point, you’ll have to achieve returns of several hundred, or even thousand percent, only to make back the money you have lost!
So, in other words, stop losses decrease the risk of getting into irrecuperable drawdowns, and work to protect your trading capital.
How big should the stop loss be?
Most recommendations on the stop loss size tend to be somewhere around 1-3% of the total account balance. This ensures that you can withstand prolonged losing streaks, without having your capital decimated.
One of the hardest tasks for any trader is to strike a balance between risk and reward. If you risk too much you might end up losing all your money. On the other hand, if you risk too little, you might instead find that the returns aren’t worth it when considering the time and effort that goes into it.
Why Don’t Stop Losses Work All the Time?
Even though stop losses are great tools that you definitely should use, they aren’t infallible. There are circ*mstances when a placed stop-loss order might not go through, and leave you with losses bigger than those of your stop loss size.
Let’s look closer at some of the most common scenarios.
Overnight Gaps
One of the reasons why some people choose to go with day trading, is that they do not want to take any overnight risk. More specifically, they’re afraid to experience overnight gaps, which means that the market closes at one price, and opens at another. With some bad luck, this could mean that the market blows past your stop loss level, without you getting stopped out. Then, as the market opens, you will get out of the trade, but at a much worse price.
Even if overnight gaps can be dangerous, it’s important to remember that the stock market makes most of its returns overnight. In other words, you could say that you are paid to take the extra risk of hanging on to trades overnight!
Poor Liquidity
Since a stop-loss order simply issues a market order as soon as the stop loss level has been hit, it’s critical that there is enough liquidity in the market for the transaction to take place.
In case there is too little liquidity, you may experience significant amounts of slippage, which basically means that your trade is filled at a much worse price, since there was no one there to take the other side of the trade.
Even though this usually happens in markets with very low liquidity, it may also happen in more liquid markets, if there is an explosion in market volatility. When there are sharp moves in the markets, you usually experience more slippage.
Trading Halts
Trading halts can last from a couple of minutes, up to several hours, or perhaps days, in a worst-case scenario. As a trader, being stuck in a position as the market closes down is a nightmare, as you don’t know when trading is going to be resumed again, or the price at which the market will open.
Mean reversion strategies
Some types of trading strategies, such as mean reversion strategies do not work that well with stop losses. Mean reversion strategies work by identifying oversold conditions and trying to catch the falling market in anticipation of the coming reversal. As such, the edge gets stronger the more a market has fallen, which means that a stop-loss would get you out of the trade when it’s at its most profitable stage so far.
We usually don’t use stop losses for swing trading strategies because of this reason. Instead, we make sure to trade those strategies with a very small portion of our trading capital. That way no losing trade will cause to much damage to the account. This approach is made possible with the help of algorithmic trading, which allows us to trade many strategies automated at the same time.
So, as you see, stop losses are by no means bullet-proof solutions. This is extremely important to realize, especially if you trade with high leverage, where large positions in combination with big swings could pose a serious threat!
Stop Loss Limit Order: A potential solution
A stop-loss limit order simply is when the market order, which goes out once the stop loss level is hit, is replaced with a limit order.
A limit order is an instruction to sell at the limit price or better.
Thus, you may have the stop loss level at $100. Once it gets hit, you may have a limit order which goes out at $90. Thus, you will get out of the trade only at 90 dollars or higher.
The advantage of this order type is that you have more control over the price at which the trade will be executed. However, it also means that you might not get out of the trade if the market trades at a price that is worse than your limit level.
Alternatives to Stop Losses
If you choose to not use a stop loss, or want to use other methods to reduce the risk of losing your capital, there are some things you could consider:
Position size
Remember that the size of your positions will have an impact on the overall risk level of your trading account. With bigger positions, eventual losses will become bigger as well. Make sure that one position doesn’t make up a too big share of your total account balance!
Trade many Markets
If you trade several markets, it’s more likely that at least some of your trades are going to do well and can compensate for those that perform poorly. Diversification across markets and timeframes forms the basis of the type of algorithmic trading we do here at The Robust Trader!
Only Trade Liquid Markets
If you go for markets with little liquidity, there is a much greater chance that you won’t be able to exit the position at a reasonable price would anything unexpected happen. With this in mind, it’s wise to stay with stocks and markets that have plenty of trading volume to support orders even in stressful conditions.
Ending Words
Stop losses are great tools that should be used most of the time, to limit downside risk in trading. However, it’s really important to realize that a stop loss isn’t a bullet-proof solution that magically will remove all of the risks involved in holding a position in the market. For example, you could find yourself in a situation where the market gaps against you, which would render the stop loss nearly useless.
However, there are other ways to decrease the risks that are involved with holding a position in the market. These include diversification across many markets, only trading liquid markets, and making sure that the size of every single position isn’t too big relative to the account size.
As a seasoned expert in the field of trading and risk management, I've spent years delving into the intricacies of various trading strategies and capital preservation techniques. My experience extends across different market conditions, and I have navigated through both profitable and challenging scenarios. Let's dissect the key concepts addressed in the article on managing trading capital and the limitations of stop losses:
1. Importance of Managing Trading Capital
The article emphasizes the critical role of managing and preserving trading capital. It underscores the irrevocable nature of capital loss and the need to safeguard against significant drawdowns.
2. Stop Losses: Purpose and Limitations
Purpose of Stop Loss:
- Risk Mitigation: The primary function of a stop loss is to prevent substantial losses by exiting a trade if it moves against the trader.
- Drawdown Prevention: Stop losses help avoid irrecoverable drawdowns, preserving the trader's capital.
Limitations of Stop Loss:
- Market Lockdowns: Stop losses may fail during market lockdowns, where trading is halted, leaving traders unable to execute their exit strategy.
- Low Liquidity: In conditions of extremely low liquidity, stop-loss orders may result in significant slippage, leading to worse-than-expected execution prices.
- Market Gaps: Stop losses are ineffective during market gaps, especially overnight, where the market opens at a price significantly different from the closing price.
3. Determining Stop Loss Size
The article suggests that stop loss size is crucial for balancing risk and reward. Recommendations typically range from 1-3% of the total account balance to withstand prolonged losing streaks without severe capital depletion.
4. Why Stop Losses Don't Work All the Time
Overnight Gaps:
- Risk of Overnight Trading: Day traders may avoid overnight gaps, but overnight trading presents opportunities for significant market returns.
Poor Liquidity:
- Slippage Risk: In markets with insufficient liquidity, stop losses can result in slippage, causing trades to be executed at unfavorable prices.
Trading Halts:
- Uncertainty during Halts: Trading halts can leave traders in uncertain positions, not knowing when trading will resume or at what price.
Mean Reversion Strategies:
- Incompatibility with Stop Loss: Mean reversion strategies may not align well with stop losses, as the strategy relies on capturing market reversals after significant falls.
5. Stop Loss Limit Order as a Solution
The article introduces the concept of a stop-loss limit order, which replaces a market order with a limit order once the stop loss level is hit. This provides more control over execution prices but may result in not exiting the trade if the market trades at a worse price.
6. Alternatives to Stop Losses
Position Size:
- Impact on Risk: Emphasizes the importance of controlling position size to manage overall risk in the trading account.
Trade Many Markets:
- Diversification: Trading multiple markets increases the likelihood of some trades compensating for others, providing a form of risk mitigation.
Only Trade Liquid Markets:
- Market Selection: Stresses the significance of choosing markets with sufficient liquidity to ensure orderly trade execution even in stressful conditions.
7. Closing Thoughts
The article concludes by reiterating that while stop losses are valuable risk management tools, they are not foolproof. Traders are encouraged to consider alternative risk mitigation strategies, including diversification and careful market selection, to complement or substitute for traditional stop-loss methods.
