Always use a stop loss order
If there has ever been one aspect that I have beaten into the hearts of traders who have graced my website over the years, it is the need to use a stop loss order on every single trade that they take.
They will keep you in the trading game, keep your losing trades within reason (assuming you aren’t trading penny stocks, in which a stop loss order won’t do anything for you), and it is going to help you consistently profit at a high rate.
When it comes to trading tools, stop loss orders are probably the most important trading aspect of making sure you do not blow out your account. You are using this order type to make sure that if the market decides to sell off and take all your positions down with it, that you aren’t holding on until it feels emotionally acceptable to sell. Instead you have already drawn the line in the sand so that you know where to get out at, instead of relying on your emotions to determine that.
By using stop loss orders, you are also making a very important aspect of trading a very mechanical one and leaving your whims of emotions, that face traders daily, from getting out of hand.
So use stop loss orders, know before you even get into the trade what your stop loss will be and never lower the stop loss ever…on any trade. If you widen your stop loss once you are in the trade, you are making an emotional decision out of fearing that the market will take you out of your trade and then rally higher. That is a horrible excuse. Whens stops get hit, there are only two directions that a stock can ultimately take – either up or down. So yes, there will be a large number of stocks that will breakout higher after you get out. That is part of trading.
When it comes to using stop loss orders you must apply these four important tips:
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Use hard stop loss orders
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Use stop loss orders work best in tight situations
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Use stop loss orders to trail profitable trades and insure you keep the majority of your profits
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Use stop loss orders to protect you from yourself
Let’s go over each one.
Use hard stop losses
It is the belief of many traders that somehow they will always be in control. That they can also react fast enough or be around when necessary to take the right actions. That is simply wrong on all accounts. The first step to trading is recognizing that you are not in control. That the market does what it wants to do and that you do not have an opinion in the matter.
You can only react to what price does to the positions that you are in. Whether it is laziness, fear or overconfidence, many traders like to use mental stop-losses.
Please, PLEASE! Don’t do that!
Mental stops are bad news. They will eventually kill your portfolio and cause you to take bigger losses than what you would have ever expected to take.
They will also kill your profit/loss ratio.
Let’s say, for the sake of conversation, that you buy a stock at $100 and instead of using a hard stop loss order, you use a mental stop loss of $95. That mental stop-loss is hit. You put your order into sell, but buy the time your order to sell the stock is placed, you have seen the stock drop down to $94.80. Only twenty cents you say? Well do that consistently, and you are going to find yourself losing a lot of capital simply because you decided to use a mental stop instead of a hard stop-loss that will get you out of the position as soon as the stop-loss price level is triggered.
But even more dangerous than the scenario that I just laid out for you, is the fact that most people who use a mental stop loss order do not have the discipline to get out of the trade immediately when the stop loss is hit.
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In fact I would say the very fact that one uses a mental stop loss order is usually due to either a lack of discipline, or a lack of faith in one’s own trading methodology.
You see, when the stop-loss is hit at $95, the initial response by the trader is to see whether it just touches the stop loss and then bounces higher, because as you all know, we all hate having our stop loss be the low tick of the stock in a given trading session, only to watch the stock spend the rest of the day recovering. So as a result, we don’t take the loss, and that very approach by its own definition, means that you are willing to take a bigger loss, just to make sure your original stop loss wasn’t the low tick.
Stops work best in tight situations
You don’t have to trade with stop loss orders that are ten percent away from your entry price. First, your risk/reward ratio is going to be very much skewed to the risk side. But more importantly, trading with tight stops will actually improve the risk/reward profile of your trading strategy that you employ.
When I trade in the Trading Block, and when I am stopped out it is usually no more than about 2-3% with most of the time it’s being somewhere in the 1% range. That means I can make at least a 2:1 profit on the risk when I profit between 4-6%. To duplicate that on a 10% stop loss order, means that you need to make 20% just to come away with the same profit/loss ratio.
Remember, the profits are in the risk-reward. If you aren’t profiting enough to cover the risk, then you simply are not profiting in your trading strategy. Keep risk tight and it makes profiting so much easier. But if you keep the risk large and the stop loss orders wide, then you will find profiting in the stock market a difficult proposition.
“But if I keep the stop loss tight, it makes it more likely I will lose on the trade!”
Who cares if you lose on the trade. That is part of trading. Get over it! If you stay in this game long enough, you will be stopped out regularly. It comes with being a disciplined trader.
Tight stops don’t mean that you will lose more either. A lot of traders think that if they profit 60% of the time on a 10% average stop loss that they will only profit 20-30% of the time with a 2-3% average stop loss.
That simply is not true. You see, tighter stops makes you look for better charts to trade and requires you to make better entries. That makes for a better trade all around. It keeps you from chasing stocks after their move is already well in progress, and makes you get in at the beginning of the move instead of the end of one.
With wider stop loss orders, you are more inclined to justify chasing price action because you have plenty of wiggle room with the stop loss and makes you less picky about where you get in at, because your stop loss gives you a higher tolerance of price fluctuation.
So keep those stop loss orders tight – you’ll profit more and more frequently.
Use stop loss orders to trail profitable trades and insure you keep the majority of your profits
Now I am not talking about using a trailing stop loss order. Far from it, I am simply saying that you should, as a position becomes more profitable, increase the stop-loss on it so that you can make sure that you walk away with a sound profit.
I am always looking for where I can, within reason, tighten my stop loss on a trade in order to reduce the risk, or to make sure I walk away with at least some profit on the trade.
But you have to be strategic about where you put the stop-loss at. You can’t simply go out there and arbitrarily place a 2% trailing stop loss on your trade, because as the stock grows more profitable, that stop-loss will eventually drift into areas of a chart that do not represent breaks of key support areas or a break of a key moving average or trend line. Essentially that stop-loss will be lingering in ‘no-man’s land’.
Instead, when I say you need to trail your profitable trades with a stop loss order, that means you regularly adjust the stop loss of the trade yourself. As the stock becomes more profitable, raise the stop loss to a key price level, that if touched, you will have a high level of confidence that the trade is deteriorating and going against you now. But it needs to be wide enough so that you can give the stock some room for normal fluctuations but still capturing the majority of the gains on the trade.
Yes, this takes much more analysis and work than simply placing a trailing stop on a trade, but in the end you want to be more profitable and that is the way you do that.
Use stop loss orders to protect you from yourself
There is another important reason why we use stop loss orders, and the final reason is not based on the technicals of a stock, instead it is based on the psychology behind the trade.
You see a stop loss orders protects you from yourself. That’s right – you me and everyone else has the full potential and capability of blowing up their account if proper risk management is not maintained and practiced on a regular basis.
If you don’t take managing risk more serious than profiting in the stock market, you are setting yourself for failure.
The best way to keep losses small is to use a stop loss. When you don’t have a stop loss in place, how do you know where to get out? How do you know when enough is enough. It is emotional decision at that point because you have to make the decision of whether to take the loss now, at the expense of the stock possibly turning around, or staying in the trade with the hope of eventually profiting, but at the risk of even losing more, if not everything.
At that point, you have to make that decision and the very fact that you are in that situation of having to decide means that you have let the stock lose enough capital that your emotions are dictating that you decide whether to sell, buy more, or simply stay in the trade.
When you have reached that point, you have already lost on the trade – plain and simple.
That is what you are preventing from happening. But that only works for you if you decide before you even get in the trade where you will place your stop loss order.
That is how you protect yourself…FROM YOURSELF.
Keeping it real with stop-loss orders
Using a stop loss order with every trade you make won’t completely eliminate disappointment with trading. There are plenty of things out there that you can do to hurt yourself when it comes to trading, but using stop loss orders is about 75% of the game when it comes to risk management. Fail to use them, and you will most certainly regret it.
I would also encourage you to sign up for the SharePlanner Trading Block. Don’t worry, there is no commitment up front. You get to see me in action for free for the first seven days of your subscription. With it, you will see exactly what it means to manage risk, place those stops, and consistently profit along the way. I have been doing this for a long time, and I make my trades well known. Because I consistently manage risk with each and every trade I make, I put myself in a position to profit on a month to month basis while maintaining a very high win rate (63% so far this year). In doing so, I eliminate unnecessary losses, and make sure profitable trades remain profitable (who doesn’t like that!?!).
So sign up for your free trial to the Trading Block. If you don’t like what you see, cancel at any time before the seven days are up. But this is the place to be if you are going to be serious about trading and making a serious income from the stock market.
You can do this!