Why some traders don’t use Stop Losses

Written by Jonbert Davidsen ∴ Friday, June 2, 2017

“If you can show a track record and an understanding of how financial markets work to employers, you are hireable." Anton Kreil

I saw a poll some time ago on the MT5 Forum. Sixty traders had answered this question:

Do you like stop loss?

Here’s the result:

A poll from the MT5 forum about the use of stop losses in FX trading.
A poll from the MT5 forum about the use of stop losses in FX trading.
A poll from the MT5 forum about the use of stop losses in FX trading.
A poll from the MT5 forum about the use of stop losses in FX trading.

41 traders answered: “I like using stop loss.” Ten traders responded: “I hate using stop loss.” Nine traders said: “I neither like nor hate stop loss.” In this blog post, you’ll explore the stop loss lovers’ and the stop loss haters’ arguments.

The Stop Loss Definition

A Google-search gives this definition.A stop loss is: “Denoting or relating to an order to sell a security or commodity at a specified price to limit a loss.” As a spread better or derivative trader, you’re in an unusual situation. You need an additional aspect. First: In Forex spread betting the stop loss relates to sell and buy orders. Forex spread betting is appealing because it’s possibile to earn money in both directions. Let’s quote Warren Buffett here:

One of my favourite Warren Buffett's quotes about trading.
One of my favourite Warren Buffett's quotes about trading.
One of my favourite Warren Buffett's quotes about trading.
One of my favourite Warren Buffett's quotes about trading.

The Warren Buffett Quote

“Trading is simple - but it’s not easy” has helped me structure my trading. Spread betting, and derivative trading is seen as a dark cloud activity by many. Its seductive nature attracts greedy and ignorant people.  It looks so straightforward - but it’s not. Most people have little or no knowledge about what trading the Forex markets means. Jared Johnson, a California currency trader, said it best 52traders.com, on the trader podcast. When Jared Johnson said: “I’m a currency trader,” the reaction would often be:

“Ohh is that legal?”

“What is that?”

“Is that like drug dealing?”

This was back in the year 2000 when online trading was new.These reactions are still common in the Forex industry, 17 years later. Spread betting is a derivative trading form where the broker offers the client to trade emulated markets. Clients can take directional bets without buying the underlying assets. I see opportunities in this trading form. That's why I blog about it.

How you think about the stop loss might have a high impact on your trading performance.
How you think about the stop loss might have a high impact on your trading performance.
How you think about the stop loss might have a high impact on your trading performance.
How you think about the stop loss might have a high impact on your trading performance.

Why do Traders Dislike the Stop Loss?

Let’s see what some traders say, who don’t like an automatic stop loss. Berich: “I hate applying stop loss to my trade. The reason why I hate using stop loss is that any time my stop loss position is hit, it means loss and sometimes, it’s hard for me to recover the loss and I observe that if I didn't set the stop loss, the position would eventually have moved in my favour.” Michael:A “problem with a stop loss order is that when you enter it into the computer, the order is transparent.” By this Michael means it enables market-makers or computer-algorithms to “run the stops.” Michael continues: “I still believe in stop losses, but not the automatic kind. Rather than using automatic stop losses, I set up price alerts for the securities I bought (and for those, I plan to buy)....I am notified by email and text message. Next, I’ll turn to my mobile device and decide what action to take.” Craig Ferguson: “Think stop loss orders will protect you? Think again.” Before, Craig always used stop loss orders. As he said: “It was just part of the trade. I would enter a trade and then immediately put in a stop loss order. It was second nature. I didn't even have to think about it.” But with time Craig noticed he was stopped out more often than usual. It frustrated him. Here’s why he changed his practice: “One day I logged onto my computer to check a stock that I was in and was pleased to see that it was going in my desired direction and my stop loss order had not been hit.” But when he logged into his broker's website he was surprised to see his stop loss was hit. How could this be? Because as he said: “The price for the day didn't even come close to hitting the price of my stop loss order!” But the explanation why his stop loss order was triggered is simple. Stops can trigger at the bid or ask price! From this Craig concluded: “If that is the case, then what is the point of a stop loss order? Your order could get filled at just any price!

Why do Traders Like the Stop Loss?

Again, let’s see what some traders say who use the stop loss. Cory Mitchell: “It is important to place a stop loss so you have a good idea how much a trade could lose. While no one wants to take a trade thinking they will lose, losses are a constant in trading, and losses must be kept in check to succeed.” Kathy Lien: “Number one rule of trading is: 'always use a stop.' This applies in particular when trading Forex because trends can last longer than many traders anticipate.” Rob Taylor: “When you enter a trade with a stop loss, you are limiting your risk, so if you are comfortable with your risk, and your potential reward, then you are trading based on a calculated trading decision, and not on an emotional hunch.”

Summing-up

The six answers represent the prevailing attitude towards the stop loss, I’ve seen online. The first three people say the automatic stop loss is a false capital preservation technique. The reason is the unintended negative side-effects with the stop loss. Berich, the MT5-forum master, found it difficult to recover from the losses caused by the stop loss. Furthermore, he often observed how his trades without the stop loss at some point moved in the desired direction. Michael saw the automatic stop loss as a problem because once it’s plotted into the trading platform, the broker can see it. He said this was a problem leading to stop loss hunting by some brokers or computer algorithms. Craig changed his stop loss approach as he learned more about the spread seen from a broker's perspective. His conclusion was orders could get filled at just about any price due to how the spread works; therefore he asked: Why use the stop loss? The last three people said stop loss orders was a good idea. Cory Mitchell saw it as a measuring tool for how much a trade could lose. Kathy Lien appreciated it because Forex trends often last longer than expected. Rob Taylor used the stop loss to lower the emotional pressure while trading. I’ve included these people because I think you’ll identify with either Berich, Michael, Craig, or Cory, Kathy or Rob. By identification, it’s easier to understand the topic.

What’s to Explain?

You consider two scenarios here: A: Should you trade with a stop loss? B: Should you trade without a stop loss? Let’s go back to the poll from MT5. The MT5 polls majority favored trading WITH an automatic stop loss. My guess is the majority in a bigger poll would show the same preference. It seems ‘trading WITHOUT a stop loss’ begs for an answer.
But let’s open-minded explore both possibilities as objective as possible. First:

The Main argument against using Stop Loss

Berich, Michael and Craig said you should avoid the automatic stop loss because of stop loss hunting. The key to an understanding seems to be some argument that’ll give you good reasons to: A) accept stop loss hunting as a FX reality, or B) reject the stop loss hunting idea. Before you examine A and B you’ll look into two ways of setting the stop loss orders: The percentage stop loss and the volatile stop loss.

1. Percentage Stop

Definition: The stop loss is determined as a fixed percentage of the trading account. 2% per trade is a typical number used by retail Forex traders. Advantage: It helps the participants to trade smaller positions. The trader can still trade the market although he has taken some losing trades. Problem: The percentage stop is disconnected from the market environment. Most participants at Forex retail level have too small accounts to set a percentage stop loss allowing the trades to breathe.

2. Volatility Stop

Definition: The stop loss is determined by the previous market-volatility. The trader identifies where the price bounces on the charts. Advantage: The trader takes the market conditions into account. Swing traders often use technical indicators such as moving averages, Bollinger bands or ATR when they set stops. Problem: This trading form requires patience. Swing traders hold positions weeks or months.

Does Stop Loss Hunting Exist?

Jarratt Davis, the founder of Global Trader Training, says: “A lot of retail traders think brokers do stop hunting.” But: “In reality that is a myth, there may be some unscrupulous brokers in some far-flung corner of the world that do practice that, however generally mainstream brokers that are regulated will not, it is very very rare. There are however some people out there that are actively hunting your stops, but it’s not your broker.” Jarratt Davis’ trading journey began in 2005. You can read his full story here. He’s a fundamental trader, and his website is worth a visit. Jarratt Davis said stop loss hunting is happening, but it’s seldom the brokers who are the hunters. Who is it then? His argument goes like this: 1. Brokers have an interest in profitable traders since they earn a commission from the trades. 2. The more profitable trades, the more commission the brokers receive. 3. In the end, the brokers get more money from profitable traders than from traders who lose their accounts overnight. According to Jarratt Davis stop loss hunting happens because large traders need buy orders to match their sell orders. Jarratt Davis adds:“To better understand this, we need to develop a deeper insight into how the larger institutions operate and how their operations affect our trading plans. The distinction here is purely down to trade size; so even though I was trading millions of dollars at the height of my fund trading career, I was still considered a ‘tiny fish’ in the same pool as the retail clients trading their micro-accounts.” Let’s look at how retail traders approach the markets1. First, you take a qualified guess where the market is headed next. 2. Secondly, you seek to time the entry, so you’re in when the market takes off. But how do larger traders approach the markets? Jarratt Davis: “Imagine that you are a large bank and that you have previously bought into the market and the market has now rallied so that you are in profit. The problem for you is that when you engage the market, you move it. This means that when you click ‘buy’, the price almost always goes up until your order can be satisfied with enough sellers. This, of course, ends up giving you a worse price. This is called ‘slippage’, and is a big issue for large-scale traders.” The same problem happens when large traders take profits. “If you just dump your position, the market is likely to revert (when closing a ‘buy’ order, you must sell it back to the market and that short, can push the price back down towards your entry point, wiping out some of the profits.)” says Jarratt Davis.When large traders liquidate or establish their positions fearful and greedy retail traders are inclined to feel, they’re victims of stop loss hunting.

Why some traders do not use stop losses.
Why some traders do not use stop losses.
Why some traders do not use stop losses.
Why some traders do not use stop losses.

The Bull, The Bear: Greed and Fear

Rolf from tradeciety.com says: “Brokers don’t hunt stops and what you reckon as stop hunting is just your inability to use stops reasonably and apply common sense to your trading.” In his blog post on stop hunting Rolf gives an example of the existing misinformation in the Forex industry: If you’ve traded months or years, you’ve perchance heard this: Let’s take some examples: • The more visible a support or a resistance level is, the stronger and more reliable the signals around it are. • Support and resistance levels are confirmed after the third time price comes back to the same price levels. • Put your buy order right at the support level and your stop right below it. Rolf trades in a different manner. Consider this: “If everyone wants to buy at a certain price, who sells?” Trading is a zero-sum equation. Every seller needs a buyer. If large traders buy at a particular support level they need someone on the opposite side. Rolfs explains his idea with two the concept of two traps: 'The Bull and Bear Trap.’ and Greed and Fear ResponsesFirst, ‘The Bull and Bear Trap.’ Purpose: Get traders to trade in the wrong direction. How it works: You want to buy at a support level after price drops. Sometimes you see price push through the support level.
It looks like the support level was too weak and the price breaks out. The bounce-hoping traders see the price come towards their stops. You remember long position stops are sell orders. Traders who waited are happy to see a (false) breakout. In the beginning, they planned to buy, but now they plan to sell the false breakout. The false breakout creates a good price. The bigger traders buy, the more they buy, the higher the price. As this continues the false sell breakouts stop losses are hit. They are buy orders because these were short positions. The large traders are now in profits. The retail traders are frustrated because now they see it was a valid idea to buy at support. “Perhaps that was just some weird” or “messy” price move. “Next time it’ll work,” they think. “It will, but not for them,” Rolf says. Rolfs example shows why a tight stop almost always will lead to a loss too soon. It’s called the bear and bull trap because it takes both retail trader sides out before the big move. Now the second trap: Greed and Fear Responses. This traps mechanism is quite similar to The Bull and Bear TrapLet’s say you have a clear support level where Trader A wants to buy. The problem is the retail traders majority also wants to buy at this level because it’s so well-defined. Here’s what will happen when the price comes closer: The greedy traders will buy as soon as they see price take off from the support level. They believe the price has already tested the support and is on its way up again. They want to be sure they buckle for the big move. When the first greedy traders group have taken their positions, the smarter and bigger traders push price further down. Soon they’ve taken out those long position. Remember the logic? Long positions have stop orders as buy orders.

The Joker

This blog post’s joker is Daytrader21. Despite his anonymous name, his argument was among the best I found when I researched the stop loss hunting phenomenon. Daytrader21’s article Stop Loss Hunting published on Dukascopy 2. February gives the perspective I believe is right. The article concludes brokers, for the most part, don’t hunt stop losses. Some countries have unscrupulous brokers reputation, but that’s another blog post topic. The author describes two methods how brokers could hunt stop losses. Both are risky.  First scenario: The broker could send one client an artificial price. At first, it seems as a broker’s beneficial, but when you consider the real risk, a broker will take to involve in such an activity the conclusion is: It’s not worth it. If they did, they risk losing their license. With no license, they’re out of business. With access to social message boards, it’s easy for Trader A to compare his data feed with Trader B from the same broker. Second scenario: The broker could send all clients an artificial price. If a broker did so there would be at least two problems with this: 1. The broker could be caught in creating advantageous arbitrage opportunities.2. The broker would have problems hedging their exposure.

“Once you get to the point where you understand what to expect, you will never again worry about brokers or institutional traders hunting your stops because you know that you are completely responsible for your stop losses.” Hugh Kimura

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