Every book written on trading notes the importance of letting your winners run and cutting losses short. From the classic Market Wizards by Jack D. Schwager we find these quotes:
Rigid risk control is one oft he key elements in the trading strategy of virtually all those interviewed…All the top traders understand that losing is part of the game.
For most traders this means using some form of stop-loss order. The problem is that traders often have a love-hate relationship with hard stop loss orders. Justin Wilcox at The Trade Cave sums up what many traders feel about stop loss orders:
Stops suck. Getting stopped out sucks, setting stops suck, thinking about stops suck and most of all realizing you picked a horrible place for a stop after you get stopped out is the worst form of suck.
He goes on to note a better way traders should frame their thoughts about stop loss orders:
One thing that has helped me immensely is to not think about stops from the view point of the exit of a trade gone bad, but to view it as simply the exit from a trade. The execution of the plan you have for the trading day should effect where your stops go more than anything else.
Some traders think they can get around the problems associated with hard stop-loss orders by using so-called “mental stops.” Robert Sinn at The Stock Sage calls mental stops “bullsh*t.” He lists a number of reasons why mental stops don’t work including:
The market can make huge moves in a very short time frame which leaves those without a hard stop in a highly unfavorable risk/reward dynamic.
The reason why stops are important is that a trader’s thesis may be correct but the timing may be off. This can be true in any sort of time frame whether it be for a trader or long-term investor. Eddy Elfenbein at Crossing Wall Street in a post on Intel ($INTC) notes the challenges he has faced in dealing with the stock. He writes:
The lesson for investors is that your thesis can be right but it may take a long time to see it pay off. I remember Peter Lynch saying that his stocks did best in the second or third year that he owned them.
The challenge for every trader is keep their capital intact during tough times so that they will be around to profit during better times. The only way to do that is keep losses small on individual trades and by extension a portfolio as a whole. Michael Martin in The Inner Voice of Trading writes:
Big losers had to have been small losers first. You have to be down 2% before you can be down 5% before you can get down 10% and so on. Cut your losers at the knees before they cut your throat.
The markets of late has been filled with all manner of volatility. Traders adhering to their discipline with the use of stop-loss orders have likely seen their fair share of whipsaws. Stop losses may suck, but what is the alternative? To quote Winston Churchill:
No one pretends that
democracy[stop loss orders are] isperfect or all-wise. Indeed, it has been said that democracy[stop loss orders are] isthe worst form of government[risk management] except all those other forms that have been tried from time to time.
Who knew Churchill knew trading as well…
Items mentioned above:
Even when your thesis is correct, your timing may be way off. (Crossing Wall Street)
Stop suck, but what’s the alternative? (The Trade Cave)
Mental stops are bullsh*t. (Stock Sage)
Winston Churchill quotes. (Wikiquote)