What happens when traders do not enter stop orders?
What is a stop loss and where do I place it?
A stop loss is an order that will automatically close your open position when a price is traded.
You MUST always enter a stop loss when you execute a trade or when you enter a ‘limit open’ trade.
(This is when you enter a buy order below the current trading price or a sell order above it).
As soon as you start to rely on mental stop loss orders (when you watch the market and decide to exit manually,
when the price hits your mental stop loss price),
you may as well just throw all the money in your account away. You will hesitate and fail to execute the stop,
in the hope of a rebound in price to save you.
Taking losses is incredibly hard for human beings to do without emotion. IT HURTS TO TAKE A LOSS.
You must therefore automate the process and leave a stop loss order in your order book.
- No trader who spots an opportunity believes the trade will be a loser.
- However the experienced trader knows losses are part of the job & must be managed correctly.
- Inexperienced traders believe they can trust themselves to activate a manual stop. They think they will be disciplined enough to exit the trade when the price reaches their ‘mental’ stop loss level.
- However the experienced trader knows that is highly unlikely to happen because it is at this stage when inexperienced traders fear they are about to exit just before the price reverses.
- The inexperienced traders draw on previous occasions when this has happened & convince themselves that this will happen again.
- The experienced trader knows that he must AUTOMATICALLY exit at the predetermined stop loss level in order to preserve the risk vs reward ratio that made the trade worth taking.
- Experienced traders know that automatically exiting the position at the predetermined stop loss level allows them to immediately move forward to the next trading opportunity – which could allow the loss to be made back & even a small profit on top to be achieved.
- The inexperienced trader however becomes emotionally entangled in the losing trade which is more likely to move further against the trader & increase the loss.
- Not only does this increase the potential loss on the trade, it also causes the trader to start to panic, try to second guess the market, to hope & pray that the trade works.
- In such a poor mental state inexperienced traders no longer think clearly, because they are driven purely by fear & greed.
- Even if prices start to move in a profitable direction the trader is frozen not knowing whether to run the trade or escape with a small loss.
- All the while the inexperienced trader is reinforcing bad habits that can lead to further undisciplined trading.
- The experienced trader has already moved on to the next trading opportunity and may be making back the small loss already. The inexperienced trader has missed out on a potentially profitable trade while nursing the losing trade.
- Some inexperienced traders will then decide to average into the losing trade (by adding to the position in a desperate gamble) rather than exit. When prices continue to move in the wrong direction, the losses are magnified & they risk losing everything.
- In the worst case scenario, the loss mounts & mounts until the inexperienced trader can no longer bear the pain. Panic sets in, forcing the trader out of the position for a huge loss.
Or the loss is so large that the broker forces the trade to be closed.
- The inexperienced trader is now totally lost & has no idea how to recover the loss. That’s if there’s even enough funds left in the account to trade again. Consumed with fear the trader is unable to make rational decisions.
- In the next stage the trader may become angry & attempt to make the loss back in one big trade. This is called revenge trading, when the trader blames the market for the loss and not themselves.
- More often than not the revenge trade leads to another big loss, sometimes wiping out the account completely.