Do you need to place stop loss?

I decided to write a post on stop loss because I find that the lesson I learnt about it in my years of trading can offer a lot of insights to traders to avoid the pitfalls I have encountered.

Definition - Stop loss is an order to sell a security (most of the time automatically) when the price reaches a certain value. For a long position, it means when the price drops below a certain value. It is meant to limit an investor’s loss in a position. Placing stop loss order allows investor to make an early decision on the price to offload the security. This helps to remove emotion especially in a situation where the security ends up in losing position.

There are many different rules for determining stop loss and I believe in general no one way is more superior than the other. Some are more suitable for a certain markets or types of security while others may be more suitable for a certain trading style.

Examples - Some of the rules for placing stop-loss are based on

• A fixed percentage below a price value (buy price, previous day close, high/low etc)
• Moving averages (eg below100 days simple moving average or below the Bollinger Band for long)
• The average true range (ATR). ATR is a measure of volatility over a specified period of time
• Support or resistance level for trend following

Learning it the hard way - I view stop loss order as a crucial component of successful trading, be it for manual or automated trading. As mentioned above, it helps to remove the emotion in the decision making especially when your trade is in a losing position and continue to spiral downwards. It has scorched me several times in my early trading days when I haven’t cultivated the habit of placing stop loss order. As the price dropped further, I realize the unfounded belief (or hope) that the price will rebound back grew stronger and the tendency to hold a losing position becomes greater. It ended up falling further, burning an even bigger hole in my pocket. After those hard lessons, I developed a habit of placing stop loss orders for every trades.

Stop loss turned market order - Over the years of trading, I come to realize placing stop loss order has its bad side. A stop loss order only means that when the price touches the stop loss level, the order immediately turn into a market sell order and it will be sold at whatever price currently being offered. So if your stock is crashing and at some point hit your stop loss, the price may drop further before your stop-loss-turned-market order is filled. You then incur a greater loss than whatever price you set for your stop. It is also the case when the price gapped during the market open and the opening price is lower than your stop. You will then be stopped out immediately. In addition, the spread is usually higher at the start of the market due to low volume so your market sell order may be filled at a much lower price.

Telling the world where you place your stop - Another thing I encountered was that after I placed a stop loss order, many times at some point, the stock price would drop until it triggered my stop, only to rise again shortly after that. It was as if someone knows where I placed my stop and tried to bring down the price so as to stop me out and buy my positions at a low price. Only after some research then I realize that my stop order could actually be visible to some market participants (eg market maker or HFT firms) who has the firepower to move prices in order to stop me (and others) out. There is even a term for it called ‘run the stops’.

Or it could be that the price where I put my stop loss is rather easy to guess and is quite common among novice traders (eg among nice numbers eg 1.05 or 10.00 or some resistant or support levels)

The use of soft stop - Anyway, I am done with hard stop loss for now. What I am currently using is what is called the soft stop. It is like a mental stop. I do not actually place the stop loss order with my broker. But via a price alerts tool I can be informed if any of my positions hit their stop loss. And I will sell my position then. However, this will again bring back the whole emotional indecision battle.

So my plan is to automate this process to constantly monitor the price movement and immediate perform a limit sell when the stop price is reached.

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