We have recently written several articles about why one should use stop-loss, and how to use it to maximize profits and limit risk.
In article 5 good reasons to always use stop-loss, you could read why a stop-loss is of utmost importance if you want to be successful as a daytrader. In article 4 ways to determine stop-loss, we reviewed the most used methods of using stop-losses.
But there are also some pitfalls to be taken care of when using stop-losses. Some pitfalls that, if you are not aware of them, unfortunately can easily transform plus to minus in your account.
1. pitfall: Stop-loss is placed too close
One can easily fall into the psychological trap that one puts his stop-loss too close to his entry price. It is very natural, as you logically want to risk as little as possible on a trade. But again, we are back to the whole problem of market volatility, as we also described in a previous article.
Because if you’re a daytrader in a market that moves on average with, for example, 10 points per bar and putting your stop-loss just 5 points away to make sure you do not lose too much, we can very easily risk being stopped almost immediately after which the market may continue in the right direction but without you on board.
The important thing here is that you decide before you trade how much you will risk on the market. We have described this in the article on risk management with R. With this method, we can put our stop-loss where it makes the most sense. Then we let the distance from entry to stop-loss define how much we set per point or how many contracts we trade.
So never try to minimize your risk by reducing the number of points to stop-loss. Instead, minimize the risk by lowering your size.
2. pitfall: Stop-loss is placed too far away
There is nothing in the way of putting a stop-loss far away from the entry price. But you must have a very clear plan with it. Unfortunately, most people do not.
One of the classic startup mistakes is that you want a lot of successful trades.
It is often expressed in the way that you trade in which the goal is just to win 10-20 points, and you then put your stop-loss 150 points away. Then there is a high probability that the vast majority of trades end in plus. Of course, the market is far more likely to drive 10 points up than 150 points down.
The problem is that this sense of success arises on a false basis. We all want to have many winners. It gives a sense of success. We can tell ourselves and others that we win 8 out of 10 trades. But of course, it’s the wrong way to celebrate the successes.
For what benefit is it when the amount that 80% of the trades you win are lost on the 20 times you lose?
The term in this connection is called positive expected value, and will soon be described in a separate article here on DaytraderLand. But in short, it’s all about being able to see that in the long run you have a good amount of profits.
This means that you do not just have to move your stop-loss far away. Quite the contrary.
3. pitfall: Stop-loss is placed without regard to market volatility
As we discussed in article 4 methods for determining stop-loss, it is very important to consider the fluctuations of the market when placing your stop-loss. It can be tempting to just trade with a 10-point, 20-point or 50-point fixed-stop, or perhaps with a fixed percentage as a stop-level.
It takes a little quick calculation if you sit and daytrade on the very short timeframe, such as the 1-min graph.
But it is worth it if you take the time to calculate your stop-loss levels and position size carefully before entering a trade.
4. pitfall: Stop-loss assures you 100%
Another illusion among many new daytraders is the misconception that they are 100% secured by a stop-loss. However, as we have also been aware of in previous articles about stop-losses, the liquidity in a particular instrument can suddenly disappear.
We must always keep in mind that the market serves as a giant marketplace, where there must always be a buyer for a seller can sell. This works perfectly in 99.99% of the time. But suddenly something unexpected occurs, which no one had foreseen, and out of the blue, all the buyers withdrew their offer.
Let’s take a concrete example.
Let’s imagine that we are long DAX at price 10,000. Our stop-loss is placed at 9,980, and we therefore feel safe and fully convinced that we can lose a maximum of 20 points. But suddenly there is uncertainty in the market. Maybe terrorist attacks, a big bank is unstable, an important politician comes with an unexpected interest rate announcement or similar major events. The event sends shock waves through the market, and DAX drops 50 points. In other words, there is no buyer at our price of 9,980. Therefore, we are first able to execute our trade at 9,950.
The fact that the stop-loss is not always being honored often comes as a big surprise for new investors and daytraders.
Insurance is possible but expensive
However, certain brokers offer a so-called guaranteed stop-loss. In this way, you are 100% sure to get out of your trade at the selected price, which, in turn, becomes more expensive to implement. This may be a solution for a little longer trade over a few days (also called swingtrading), but if it is completely short-term daytrading then an insurance will take too much of the profit.
5. pitfall: Stop-loss is moved the wrong way during the trade
This is probably the ugliest and most expensive pitfall you can fall into as a daytrader and investor. One has made his analysis, determined an entry, found a sensible stop-loss level and calculated the position size on his daytrade. Everything is clear and well-thought out before executing the trade.
Let’s go with the long position from the example above, where we bought DAX at 10,000 with a stop-loss at 9,980. Just after our entry, the market now begins to fall. First 5 points, then 10 points, and sudden we are down 18 points and now only 2 points from our stop-loss.
Now, many people begin a mental thought process, beginning to find arguments for why the stop-loss should be lowered. One can suddenly see that 9,980 was too close to that. The stop-loss should clearly have been placed at 9,950 instead. That’s why you just move your stop-loss 30 points further away. This gives a short-term relief, as the market is now far from your stop-loss the level, and thus the trade can still be successful.
But this is an absolute death sentence when it comes to the art of placing a stop-loss.
Your stop-loss may be moved, but only in the direction of the trade.
Because we do it in the direction of the trade, it’s just our trailing stop-loss, where we quietly reduce our risk and gradually begin to lock in profits.
6. pitfall: Stop-loss is placed at an area too obvious
It’s a great temptation to place the stop-loss just above or below an obvious swing point.
In the textbooks on technical analysis, we can read that if the level of support has been hit a number of times, the stronger it is. This is, in principle, also correct. But the more times a level is tested, the more traders are long and short trades around this level.
In particular, the levels around the large round numbers such as 10,000, 10,500 etc. is always in focus. Here, it is easy for the market to cause a stop-hunt, after which a massive amount of purchase orders will return the price above the level of support. This happens to most daytraders a number of times.
Over time, one learns to keep the stop-loss levels some points away from the most obvious levels.
That was all about the different pitfalls of using a stop-loss for this time.
If you have not read the other two articles about stop-losses, we recommend that you do so now. In article 5 good reasons to always use stop-loss, you can read why using a stop-loss is of utmost importance if you want to be successful as a daytrader. In article 4 ways to determine stop-loss, we review the most commonly used methods of using a stop-loss.
Do you have comments, own experiences or tips? Finish a comment below.