The stop loss is a useful tool for traders of all levels. Its purpose is to protect against the risk of loss, reduce those that appear inevitable, and conduct rational trading activities that incorporate, channel, and contain negative consequences.
However, the stop loss can prove to be a double-edged sword. If used incorrectly, it can cause more harm than good, even leading to a substantial
loss of assets.
Therefore, knowing the improper uses is essential. Obviously to...
Avoid them.
What is a stop loss
Before discussing the improper uses of stop loss, it is important to provide a definition that is as accurate and stringent as possible.
A stop loss can be defined as the price at which
the trader "forces" an exit from the market. The purpose is clear: to avoid the worst. The stop loss allows for withdrawal when the trade can no longer recover and is therefore destined to generate losses upon losses.
In short, the stop loss is a tool for controlling losses. It is a weapon of money and risk management, and therefore essential for trading activities that want to be called, if not scientific, at least
rational. Without tools like stop loss, trading risks becoming improvisation, even leading to
gambling in the truest sense of the word.
However, it is evident that the stop loss is a difficult tool to master. Identifying the exact point at which to place it is complex and involves in-depth analysis activities, which must be combined with personal evidence regarding
one's ability to tolerate losses. A stop loss is truly effective when it identifies the exact point of no return but, at the same time, does not jeopardize the trader's financial capabilities.
The improper use of stop loss
Hence, the rather high probability of incurring setup errors. In short, an improper use of stop loss. The behaviors to avoid are as follows.
- Setting the stop loss too high. If the stop loss is set too high, there is a risk of exiting the market when the chances of winning are still greater than zero, if not even high. The worst prospect is witnessing a revaluation of the asset once the stop loss has been triggered.
- Setting the stop loss too low. In this case, the risk is generating significant losses and delaying the exit from the market. This is a drift that can jeopardize the trader's financial availability.
- Preceding the stop loss elaboration with a hasty analysis. Generally speaking, all stop losses developed following an overly rapid and superficial market analysis are potentially disastrous stop losses.
- Considering the stop loss as a cage. The stop loss is a substantially automatic exit mechanism, but it should not be inescapable. In short, the trader must be able to take control of the situation if market conditions change so much that they invalidate the stop loss calculation.
How to use stop loss
So, how to use stop loss correctly? Let's start with the general principles. The most important one consists of putting forth the maximum possible effort in its calculation, and therefore
in market analysis. The necessary evidence is often contained in the charts, especially if the day is "quiet" and does not foresee the publication of critical news.
Another important principle is to adopt a flexible approach. The stop loss should be calculated and set, but it must be
surpassed if the situation requires it. In short, the trader must put themselves in a position to take
the reins of the game firsthand, regardless of the stop loss.
A more practical piece of advice, on the other hand, is to adopt an analysis approach consistent with the time horizon of the trading. The usable methods are numerous, but the point of no return must be sought in the asset's past, in a study of what happened before. What kind of past? What time frame should be considered? It depends on the expected duration of the position.
