One of the common email questions I get through my website relates to difficulties in sticking with stop losses.
Some traders don’t place one in the market at all, promising that they’ll get out when price hits a certain level. Of course, when price gets to that level there’s no shortage of reasons why they should hang in there just a little longer. If they let it run just a little further it’s sure to move back into profits.
Other traders have no problem placing their stop. But for some reason, they decide to remove that order from the market before its hit.
Well, I got another email this morning – “…Sticking to stop losses is my biggest downfall, any suggestions?”
This particular question came from someone who says they’re fairly new to trading, so I think it’s great they’ve recognized this problem so early. Well done. But it’s such an important question and such a common question, that I felt I should share my answer.
Firstly, difficulty in sticking to your stops is certainly a common problem – so don’t feel too bad about it. This means it’s not just you – others have been through the same issues, and overcome them. So there’s no reason why you can’t do this as well.
The difficulty is getting rid of this bad habit. Traders say that they understand the need for the stops – they see the danger in letting the trade run – but for some reason even if they had full intention of exiting at the stop loss, they still let it run, either by not placing the stops at all or by removing the stop once it’s in the market.
Where does this problem come from? Well, I could write a whole book on this, but let’s try to summarize it here.
Basically I believe the problem is fear. Not just the fear of a small loss of money occurring with this trade, but a much deeper fear at the very heart of your trading endeavor and your life. What does total failure to become a trader mean to you? What does losing all your money mean to you? What does that mean in terms of your opinion of yourself? What will your family think of you? What will your friends think of you?
This is what you’re risking every trade, because every small loss takes you potentially one step closer to ultimate failure.
So, even if a person rationally understands the need for stops, and places a stop in the market with full intention of following their plan, they succumb to the greater fear as the trade approaches their stop loss and remove it from the market. After all, the nature of the market is ‘uncertainty’, so it can surely come back from here and get into profit again. And you can ALWAYS find further technical analysis to support your decision to remove the stop, and hold for just a little longer. And there will ALWAYS be other analyst or news opinions to support the decision to remove your stop.
Sorry if this sounds all rather dramatic, but its reality and it will continue to happen until a person learns to manage their trading decisions despite their emotions. (Note that I didn’t say ‘control’ their emotions. Too many people say that you need to control your emotions, or trade without emotions. Rubbish! You’re human and the emotions will happen no matter how much you want to control them. You cannot overcome them by willpower on a consistent basis. You rather need to find strategies to manage your trading decisions despite these emotions).
So, the way forward:
1. Establish total confidence in your system – ensure thorough back testing and forward testing so that you KNOW it provides you with an edge, despite small losses. This will reinforce the fact that small losses are part of the system, and can’t hurt you over the long term.
2. Compare results had you let stops run – go over your historical trades, and compare results had you not got out at your stop. Initially you might find that many of them did come back. However work out how much money you can afford to draw down before you either lose everything, or the pain would become unbearable. Then all you have to do is find one or two that don’t come back before getting to this point. This will reinforce the danger of letting your stops run.
3. Ensure stops are always placed in the market. If your broker doesn’t allow for an exit order attached to an entry order, get a new broker. Despite the fact that some traders still remove the order once it’s in place, it is still harder to do that than not placing one in the first place. So make sure you always place an exit order at the same time as your entry order.
4. Ensure you have a documented trading plan, and procedural steps (eg. checklist) for trade entry, management and exit. Ensure that there are no circumstances within your plan that allow for removal of your stop loss. Then as you trade these steps, act as if you were two people (stick with me here, I know it’s getting weird) – firstly you’re the trader, and secondly you’re the boss of your trading firm who is a real fan of risk management and following rules. For every action that you as a trader make in entering or removing an order from the market, pause and assume the identity of the boss of the business – would you be happy with the decision that your employee is making, or would you overrule it? Would you sack the trader if he makes the decision he’s about to make? Often this is sufficient to overcome the problem. Assuming the identity of the ‘boss’ or ‘risk management guru’ allows our rational side to come through and reinforce the need for taking our small losses.
5. Use an accountability partner. Explain your problem with someone independent from your trading, perhaps your wife, husband or a friend, and ask if they are happy to assist with your trading through ensuring compliance you’re your plan. Then, after each trade (or trading session or week), show them each of your trades. Show them evidence of the stop placed at entry, and held till exit. Enforce some form of punishment if you break your rules – make it something you will really hate. Often we find that it’s easier to hold the stops if someone else is depending on us to do so – the fear of embarrassing ourselves through showing poor discipline can often be enough to counter the fear of loss, and keep your stop order in the market.
It’s a difficult problem to overcome. But through building confidence in your trading strategy through thorough testing, and through disciplined application of your plan with the assistance of your ‘alter-ego’ boss and your accountability partner, you can overcome this. Never give up.