The importance of a Stop Loss and the impact on a trading account.
Trading is not a sure thing. Far from it. You could be following the best of the strategies and still not be profitable if you let your losses run in trading.
That’s the thing. You have to protect your capital to be in the game because the losing trades could be as many, or more, as the winning trades. If you make and lose equal amounts in winning and losing trades, you will just be wasting time.
Worse, if you lose higher in each losing trade and win lower in winning trades, you will be out of the game sooner than you think. This is exactly what happens to naive traders. They take their profits quickly and let the losses run.
This is where the stop losses save you. Loss aversion, the tendency to not take losses, is a physiological limitation. The traders who understand that and train themselves on sticking to stop losses become immensely successful even with their average trading strategies.
The cost of letting the losses run is very high for every trader. You would be risking losing your shirt if you do that. Sample this, a 10% loss on your capital needs you to earn an 11% return to get back to your original capital, while a 50% loss on the same capital will need you to make a 100% return to come back in the game. That’s a pretty tall feat.
Let’s look at a hypothetical situation in which you start with a $1000 account and place 20 trades. Let’s assume further that you make profits half the time and lose half the time and the outcome of each successive trade was opposite of the outcome of the previous trade. So, for example, if your first trade was profitable, the second was loss-making, and third was again profitable with the next loss-making and so on.
Now, if you make an equal rate of profit and loss (let’s say 10%) in each trade, you will be down slightly to $904 by your 20th trade. On the other hand, if you make a 10% profit on each profitable trade and a 5% loss on each losing trade, your account will up to $1552 by your 20th trade.
So far so good. Let’s tweak the situation a little bit more
Assume that you make 10% on each profitable trade and lose 15% on the losing trade, you will down to $510 by your 20th trade and to $260 by your 40th trade. At his pace you will be out of business pretty quick.
Here is a table showing the above hypothetical example.
Real life situations are not as straight as the one shown above. If you sit on a leveraged losing position for long, you might not last more than five trades because leverage is a double edged sword that accentuates both, your profits and losses. Therefore, it becomes even more important to follow stop losses when you are trading on leverage.
Stop losses are like insurance premiums that a trader should pay to stay in the game and the sharpest of the traders understand this extremely well. This is in fact the ultimate success mantra, because more than half of the traders get thrown out of the ring just for the lack of basic stop loss discipline.
Developing the stop loss habit isn’t too easy though. You need a lot of practice and mental power to stay objective while you are trading. You will be wrong often in taking losses too, when the price will reverse right after you took that loss. But, the key here is to understand that it’s the part of the game and you should not lose your mind over that.
It’s like any other business. Not all your deals will be profitable and not all of them will make you equal profits. Some will be home runs while some will be duds. But you need to live with them and improvise, learning from your mistakes, protecting your capital and cutting your losses short at all times.
You may also like our article and calculator in relation to stop losses and the associated risk reward ratio HERE.