Definition – Stop Loss
A stop-loss order is defined as an order to buy or sell once a specific price has been hit. Traditionally developed to limit the loss of an individual in a specific security, once the security moves in the opposite direction of the initial expectation; stop-loss order is modified to enter and exit the market at certain prices.
A stop order could be broadly classified into two, i.e., a buy stop order – an order to buy a security at a specified price above the current price and a sell stop order – an order to sell a security at a specified price below the current market price.
The stop order can be further refined by adding a limit, aka stop loss-limit order to change the order into a limit order once the stop is triggered.
How are Stops Used for Entry and Exit?
Stop orders, also called stops could be used to enter or exit an open position in the market, and technicians and traders, who follow technical analysis, use the same to enter or exit a position above and below a resistance level and a support level, respectively.
For entry purpose, suppose if a price is approaching a resistance level above which a new trend is expected to develop, a buy stop order could be placed to be triggered if the resistance level is penetrated post a breakout.
Likewise, an entry stop order could also be placed to sell short once the specified level had been breached.
Contrary to entry stops, exit stops are used either to protect capital from further loss (protective stops) or to protect profits from deteriorating back into a loss (trailing stops)
Both protective and trailing stops are defined as defensive stops as they protect investors against a sudden capital loss or fall in profits.
- Protective Stops
Not every entry in the market goes as per plan and ends up with a profit, and many traders have more losing trades than winning trades, yet many of them are able to take the profit out of the market because of the judicious use of their stops.
Traders usually place a proactive stop loss below the price level, where they anticipate that the market would change the behaviour. Once the market reaches that point, protective stops usually get triggered, taking the trader out of a bad trade, and when the market does not reach that price level, the protective stops allow the trader to run the trade until reversal sign emerges.
Furthermore, protective stops also decide what capital risk the trader or investor is accepting in a trade. By selecting a capital risk, establishing a stop level, and placing an order to that effect, the trader knows exactly what capital risk is being taken.
Protective stops are usually placed around the crucial resistance or the support level, only.
- Trailing Stops
A trailing stop could be used to avoid the potential loss of profits when a trade is already in profit for a trader. Many technicians or traders also call trailing stops “progressive stops”. These trailing or progressive stops are necessary because, in a major trend, the prior support or resistance may give a substantial price distance from the current price; thus, putting the capital gain on a risk.
Trailing stops are usually favourite among trend traders, who systematically change their capital risk with the directional trend of the underlying security.
How Directional Traders Generate Trailing Stops?
- Trailing stops using a trendline
One of the easiest methods of identifying or generating a trailing stop is to follow the trend line with a confirmation filter. Confirmation filters such as close filter, percentage filter, volatility filter, along with the trendline, is a very good method of identifying a strong level for trailing stops while avoiding price whiplashes.
However, this method requires daily monitoring and readjustment of the stop level, and another shortcoming of the method is that it does not take current volatility into consideration while deciding the trailing stop.
- Chandelier exit
Chandelier exit method considers only the price and the intrinsic volatility to decide on the trailing stop level via measuring some fraction of the security’s Average True Range (or ATR) from its latest reversal point.
Suppose on a given day a stock reversed from $100, and the present 14-day ATR is 5. Based upon the market strength traders usually decide a multiple of 14-day ATR below which they would like to place a trailing stop.
For example, a trader may choose to take a 3x of ATR to decide the trailing stop while another may choose to take 6x of ATR for the same purpose.
- Parabolic SAR
Many trend followers use parabolic SAR to decide the trailing stop. Originally developed by Welles Wilder in 1978, SAR stands for “stop and reverse”.
Changing Stops and A Lesson To Abide
The most important underlying principle concerning defensive stops is that they should never be moved away from the trend of security as they imply that the original analysis was wrong.
A trader or investor, who changes or cancels the stop loss, especially when the underlying security is trading at a loss, generally lacks discipline and are more prone to emotional whiplash or emotional decision pressure, which is one of the leading cause of capital loss in the financial market.
Do you need stop-loss if you are winning and losing big?
Consider a situation, where there are two traders; and the annual returns generated by them are as below:
At first glance, it might look like that Trader A is clearly outperforming Trader B with a mean average return of 55 per cent over 4 years as compared to the Trader B’s mean of just 36.0 per cent in the same tenure.
However, one needs to analyse the above data with elementary maths and one important thing about investment returns, i.e., they are multiplicative in nature rather than addictive.
So, if we assume that both the traders had $100 as an initial investment, let us take a look at their net profitability at the end of Year 4.
Despite a large gain profile and a higher mean average return of 55.0 per cent, Trader A ends the session with a net loss of 53.2 per cent.
And, despite a low gain profile and a low mean average return of 36.0 per cent, Trader B ends the session with a net gain of 241.43 per cent.
If you have made a 10 per cent return instead of 25.93 per cent, it will take you ~2.5 years to grow your money by 25.93 per cent instead of one year; however, if you lose 25.93 per cent in the first year, it will take some time to reach breakeven.
Thus, it becomes paramount to always limit your loss and be aware of your capital risk.