If you were a boxer, you would inevitably receive some punches during a match. The important thing is not to take a hit so hard to knock you out. If you do, the game is over and if the punch was hard enough, your career could be over as well.
When you are a trader, you have the same task in front of you – to survive. The parallel with boxing shows you that the small punches are not a big deal, you can still win the match. Same thing on the market. Small losses cannot be avoided and they will not prevent you from being a successful trader someday. But if you lose your whole account in one or two deals, the psychological pain will be so much, that you would probably give up trading.
So the question is how to endure only small losses? Boxers train hard in order to avoid being knocked out. Experienced traders use stop-loss orders.
A stop-loss order is an order you send to your broker. If the price of the instrument you have an opened position in, reaches the level of your stop-loss order, you are immediately exiting the trade. The hit stop-loss means that things did not go according to your plan and you have to cut your ego and acknowledge you were wrong by saying goodbye to a small portion of your stack.
If your ego is bigger than it should be and you have not put your stop-loss order, prices could go against you forever until eventually all your money is wiped out in a single trade.
Now let’s examine a hypothetical situation with and without a stop-loss order.
In the above shown situation you decided to buy, because the trend was up and you know that trading with the trend is always better. But you know that no trend lasts forever, so you have put your stop-loss in place to guarantee that if things go wrong this will not be the last trade in your life. A little time passes, it turns out you were wrong and your stop-loss order is hit. As you can see, the amount of money you have lost is not very large. So the trade is not fatal to you and you can move on to the next one. Now let’s see what happens without a stop-loss to protect you.
The reason to buy is the same, but this time you were so confident in your success, that you decided you do not need a protective stop. But then the market proves you wrong, prices start declining, the loss is getting bigger and bigger with each point to the south and you simply do not want to admit your mistake. So you wait and wait. You hope for the trend to reverse in your favor, but it never does. Now you wish you have had put a stop-loss.
If you want to stay on the market for good, you need to remember that nobody is always right. No-one has only winning trades. Everyone loses sometimes, even the big sharks on Wall Street. In fact, the missing stop-loss orders are the reason why some of them commit suicide, when the market suddenly crashes.
In conclusion, you MUST use protective stop-loss orders, because, like George Soros once said, “It’s not whether you’re right or wrong that’s important, but how much money you make when you’re right and how much you lose when you’re wrong”.
Hanging gloves image by www.azracing.gov