Saturday, 30 July 2016

Why Stop Losses are Counter Intuitive

(Source: Forbes)

I'd like to start out this article with a personal story. When I first started trading, I made one of the worst mistakes any trader could make, which is to not adhere to your predefined stop loss level. I would enter a trade, if the trade went in my favour, I'd start to move my stops to tighten it. But if the trade went against me, I'd start adjusting the stops to make sure that I wouldn't get stopped out. (You're probably cringing)

If you are new to trading and you're struggling with sticking to your stop loss, keep on reading.

I ended up losing more than expected, and closing winning trades way too early. Perfect recipe to wipe your account out. As humans, we are psychologically predisposed to be excited when we see the small gains. But when there is a losing trade on hand, we become optimistic and hope that it will eventually reverse. Its known as prospect theory people value gains and losses differently.

A simple example to demonstrate this theory would be the following scenario:

Imagine if you could either have $100 now or a 50/50 chance of either getting $0 or $500. I'm pretty sure most of you would just take the $100 although logically, you should pick the second option.

I think I might have a solution to help you cope with sticking to stop losses.

The term "Stop Loss" has a negative connotation to it. It makes us feel like we've made a mistake.

"Stop playing with your gameboy!"
"Stop watching tv!"
"Stop adjusting your stop loss!"

Just things I've heard my mum tell me growing up. Okay, maybe not the last one, but you get where I'm going with this.

"Loss" is pretty self-explanatory.

So instead, let's rename "Stop Loss" to "Start Save". Adhering to the stop loss levels enables you to prevent additional losses saving your capital. It also gets you out of trades that are not going in your favour and frees up your capital for other opportunities that might present themselves.

I hope this has helped you to understand why following your stop loss start save level is crucial to trading.

As always, happy trading.


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