Limitations of Stop Loss Order
Stop loss orders are simply a tool. There is nothing wrong with them when used properly and with the proper expectations. When a trader works within the confines of the ability of a stop, then the frustration of stop orders can be diminished. The simple fact is that when you know what to expect you can’t be disappointed.There are three situations that occur in trading that using a stop loss order can’t protect you from: fast-moving markets, consolidating markets, and general shifts in supply and demand.If the market you are trading experiences any one of these scenarios, then a stop-only approach to trading can and will backfire. In a fast-moving market the stop is triggered, turns into a market order, and you get the worst possible fill, known as slippage.In a consolidating market, if your stop is too tight the market will hit your stop loss price, turn into a market order, and get you filled; and then the market will turn in the direction you expected all along.If a fundamental shift in supply and demand occurs, the stop order may be a victim of being placed too far out to compensate for consolidation, and will be triggered into a market order that most likely will exceed any initial money management strategy that was set in place to help protect a trader’s account principal in the first place.The stop loss order has been promoted and marketed as a one-size-fits-all solution, and in the process it has done more harm than good.Last Resort of a Desperate TraderStops, by their very nature, are a reactionary tool. They are triggered only when the worst possible scenario can occur in a trade. By that time it is really too late to do anything.How can you realistically operate after a stop has been triggered?If your technical indicators suggest that you reverse your position, then how do you do it without chasing the market?If you do end up switching your market position, how can you be sure you won’t be stopped out again, thereby compounding your losses?If your technical indicators suggest that you stay in the position, how can you justify ignoring your money management rules that tell you to get out?Loss of capital, slippage, plus the high degree of uncertainty that a stop loss comes with make it difficult for a swing trader to strictly rely on it as a risk management tool. The stop loss order can only do just that—stop loss—and it doesn’t even do that all that well. Unfortunately, stopping a loss is not the same as managing the potential risk of loss. One is proactive, the other reactive. The reactive nature of a stop loss means that it is effective only in times of desperation, when the trader simply can’t take the pain anymore. This is not how pros trade, and neither should you.
