Friday, August 12

Stop loss: the art of cutting losses

There is seldom so much consensus in trading. If there is something that is essential, it is the stop loss, the limit that often separates success from failure.

Even the most veteran traders do not have the luxury of opening a trade without knowing first what is the maximum loss they can bear.

Identifying a trend is important to get on it, but even more critical are the tools that the trader needs to discern when that trend has come to an end and can generate a serious bankruptcy.

The importance of the stop loss

On paper, the trader’s plan may be impeccable but the market is like a living being, it is always registering continuous oscillations, often unpredictable because of news that triggers volatility.

Some investors believe that the stop loss can be dispensed with because they have the position in the lead. It is the first big mistake. «The stop is always essential to avoid more than one upset. No matter how furnished the head is, the market can always play a trick on us or there may be concentration errors, “he says. Josep Codina, head of analysis of the magazine INVERSIÓN.

The acceptance that no trading system is foolproof naturally results in the need for a stop loss to cut potential losses. Sooner or later the market will turn against you. Therefore, the key is not to open a position without first knowing what the maximum loss that can be borne is.

Accept the degree of risk aversion

From this point of view, “stop losses have to do with the investor himself and his degree of aversion to risk,” he adds. Pablo Garcia, director of Divacons Alphavalue. Investors who are more averse to losses, will have to tighten it more and those who can withstand moments of more volatility can leave it less tight.

In any case, the level where the stop loss is placed is never random and must always be collected before opening the position. In fact, as they explain Carlos Doblado and Isaac de la Peña in the book ‘Fundamentals of technical analysis », the stop “must be linked to the arguments that led to the establishment of a position.”

Thus, stops “must be placed according to our system or according to our operating hypothesis,” Codina insists. After all, the function of the stop is to take the trader out of the market when he is wrong. And since no trading system is infallible, when the arguments that justified the entry disappear, the stop must be executed.

Evidently, there will be certain occasions when the stop loss will jump false, but in the long term the damage will always be less than if the losses are allowed to run without any kind of brake. This happens more often than it might seem, but it is always better to respect the stop loss, he emphasizes Codina. 

The temptation to move the stop loss

Precisely, one of the big mistakes that many traders make is to move the stop loss when the position has already turned against them. It is a very human reaction, because nobody likes to lose, but it almost always leads to disaster. «The first rule of thumb is that the stop loss never goes away no matter what happens.

That is, if you trade long you cannot go down and if you go short you cannot go up. It is the first rule above all, “he says. Uxío Fraga, director of

Breaking this golden rule “generates horrible results, especially on the psychological side, since the trader is betraying himself and does not trust his own operations,” insists Fraga. “It is a mistake that no trader who considers himself as such should make,” he emphasizes. Codina. 

Another different thing is to go up the stop as the price moves in favor of the trader, but always maintaining the same distance that was considered when opening the position. “A stop can only be moved in our favor, that is, to adjust to further reduce the initial loss assumed or, if necessary, protect the benefits of a position,” he recalls Codina.

In his opinion, «This has to be one of the fixed rules of our trading plan, the success of which will have a lot to do with how well placed our stops are ”.

How to place a stop loss well

All in all, the true power of a stop loss is knowing how to place it properly. The point is, there is no one rule that works in all markets and in all situations. Stop placement is an art, the fine line that separates winning traders from losing traders.

“There can be multiple techniques, based on the backtesting of our systems if we are systematic, and they can have variable values ​​for each different input”, he reflects. Codina. Traders with a more discretionary style, have to stick to the arguments that motivated their entry into the market.

When they are no longer valid, “the reason for the operation ceases to be in force and we have to abandon due to the fact that our hypothesis has not been fulfilled,” recalls the INVESTMENT expert. The true power of the stop loss is knowing how to place it properly and based on the input arguments.

The stop loss must match the monetary management

For example, if the investor operates on the break of an upward channel, he can expect a test to the breakout zone, but if the price gets back into the channel, the hypothesis will no longer be fulfilled and the stop should be there placed.

It must always be borne in mind that the stop has been taken as a reference to set the size of the position and balance it with the monetary management, thus limiting the real risk assumed by the trader.

In the opinion of Uxío Fraga, The second golden rule is that “the stop loss is placed according to a geometric criterion, according to what the price draws, but never according to any mathematical criterion.”

That is, it should never be below the moving average, for example, or one euro away from the entry point. What is relevant is the geometry of the price, the defensive points, the retracements, the advances or the overlaps of the candles.

Defensive points

In normal markets, not too aggressive, Fraga suggests to go detecting the defensive pointss to gradually place what is known as a trailing stop. These defensive points can be very diverse. From more or less violent corrections to lateral sections or congestion areas.

In the most volatile markets, this expert is in favor of using the “confidence limit” indicator, which many trading platforms often have.

The point is that there are multiple techniques to place the stop loss and all of them can be valid depending on the market that is operated. But the important thing is to keep in mind that stops are not just life insurance. In the end, they allow you to make a fully reasoned decision based on the projected benefits and the risks assumed.

As they remember Doblado y de la Peña, “Technical training allows estimating a theoretical minimum target for the subsequent development of prices, which will be met frequently.” This is the minimum distance that the price should travel. Knowing the minimum objective and the stop loss, the ratio between both magnitudes allows the risk / benefit equation to be obtained.