Last Updated on 10 February, 2024 by Rejaul Karim
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.
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 circumstances 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.
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!
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 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:
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.
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.
Do stop losses always work?
No, stop losses do not always work. While effective in preventing big losses in normal market conditions, they have limitations. Stop losses may fail in scenarios like market lockdowns, extremely low liquidity, and when the market gaps against you.
How big should a stop loss be?
Most recommendations suggest a stop loss size between 1-3% of the total account balance. This helps traders withstand prolonged losing streaks without risking excessive capital depletion.
How do overnight gaps impact the effectiveness of stop losses?
Overnight gaps pose a risk as the market may open at a price significantly different from the stop loss level, resulting in trades being executed at worse prices than intended. Traders may experience higher losses than anticipated due to overnight gaps.