Importance of Stop Loss Order and Why You Should Use It

Risk Taking In Trading Derivatives

Futures and options trading draws many traders and investors due to the leveraged nature of derivatives. Leverage can run five to twenty times or more, depending on the margin charged on the specific derivatives product. Assuming a trader holds a position in the FKLI (FTSE Bursa Malaysia KL Composite Index Futures) contract at 1600 index points, equivalent to a notional value of RM80,000 (RM50 multiplied by 1600 Index points). If the margin paid is RM4000 per contract, the value of the contract is twenty times larger relative to the margin. Leverage allows a large position size with a relatively small capital outlay. A single percentage point move on the underlying FBM KL Composite Index would translate into a twenty-fold percentage gain or loss in the trader's margin, depending on whether the position was long or short the FKLI.

The example above shows leverage's power in amplifying returns and losses if risk management is not applied judiciously. Every trade carries with it a promise of handsome gains and the potential for disastrous loss. One of the critical elements of a solid trading strategy is managing the losses when markets are not moving favourably to your position.

Accepting That Not All Trades Will Be Winners

Risk management is the paramount factor for successful traders. Successful traders learn to accept that not every trade will always be a winner. That is why they always have a stop loss as the safety net to manage unavoidable losses. A stop-loss order is placed on every trade at a predetermined level at which a trader exits a losing position to prevent further loss. The stop loss order is a crucial and powerful tool in a trader's risk management toolbox.

A pilot would not take off on his plane without a defined flight plan and knowing where to land; likewise, the trader also needs to plan for exits every time he enters the market.

Even if you have an excellent system for identifying entries, if there is no plan for exiting losing trades, the profits can be wiped out when the market turns against you. By setting a stop loss order at a reasonable level based on your risk tolerance and trading strategy, you define the maximum amount you are willing to lose on a particular trade.

 

Stop Lossesalso provides emotional control for the trader. Trading can get very emotional, especially after you experience a string of losses.Fear of further loss and hoping for a recovery can affect a trader's judgment, causing them to hold onto losing positions for too long.

You can reduce emotions from the equation by using a stop loss to automate the exit decision. Having a stop loss helps you stick to your strategy and avoid the pitfalls of emotional trading.

How To Implement A Stop-Loss Strategy

Different ways exist to implement stop-loss orders, depending on the trader's trading style, time horizon, and risk appetite. Here are the various types of stop loss orders:

• Fixed Dollar Stop: Traders set a specific dollar amount as the stop loss level. For example, if a trader buys a futures contract at RM4000 and puts a fixed dollar stop at RM3950, the position will be automatically closed if the price falls to RM3950.

• Percentage-based Stop: In this type, the stop loss is set as a percentage of the entry price. For instance, a trader might place a 5% stop loss on an RM4000 position, triggering the stop order if the price drops to RM3800.

• Technical Stop: A technical stop loss order is based on charts or technical analysis where the stops are placed above or below price supports and resistances or important swing points on the chart. A breach of those price points would signal that the direction of the trade is wrong and exit the trade.

• ATR-Based Stop: The Average True Range (ATR) is a volatility-based indicator that can be used to determine stop levels. Many traders use 2 or 3 multiples of ATR as a stop loss level. The position will be closed if the market moves away by 2 -3 ATRs. Using ATR allows traders to set their stops at a distance reflecting current market volatility, ensuring they aren't stopped prematurely by normal price fluctuations.

• Trailing Stop: Trailing stops are dynamic and move in tandem with the market price, maintaining a set distance away from the current price level. They allow traders to lock in profits as the price moves favourably while protecting against potential losses.

For example, if you bought a futures contract at RM4000 and it is trading at RM4300, you may put a trailing stop at RM4100. As the market continues to trade upwards, you will continue to adjust your trailing stop upwards; say, if it trades to RM4500, you will trail your stop to RM4300, and so on as prices increase.

Why Traders Avoid Stop Losses

One of the main reasons why traders may find it tough to apply stop losses is the fear of loss. This fear is an overpowering emotion that commonly hounds the novice trader, stemming mainly from the inability or refusal to admit that the trade has gone wrong.

Often, traders also avoid taking a stop loss since their past trades were able to recover by sitting out the positions; however, there will be a time when price movement continues against the trader until the loss is so substantial that there is no longer a choice but to liquidate the position. However, this kind of thinking is detrimental. The stop loss is there because not every trade will be a winner. To be a successful trader you must understand that taking small, manageable losses is part of the game, and the stop loss helps mitigate the damage from a losing trade before it spirals out of control.

Taking A String Of Losses – Drawdowns

Drawdowns refer to a trader's account equity decline from its peak value due to a string or series of losses.Being able to handle drawdowns is also a crucial aspect of risk management. Understanding how to handle drawdowns effectively can make the difference between a resilient trader and one who succumbs to emotional decisions.

It is essential to acknowledge that drawdowns are a natural and expected aspect of trading. No trader, regardless of experience or expertise, is immune to drawdowns. Understanding and accepting this reality can help manage the emotional toll that drawdowns can take on traders. Keeping stop losses manageable is essential to survive drawdowns and lessen the loss when it happens. By recognising drawdowns as part of the trading process, traders can focus on analysing their trading strategies objectively and find ways to minimise future drawdowns.

Stop losses is a safeguard and forms the backbone of a robust risk management strategy for traders. The disciplined use of stop losses can distinguish between the successful and the losing trader. The stop loss can be likened to a safety airbag, providing an essential safety net in a sudden market downturn or when the trade goes wrong. Just like a driver would not operate a car without airbags, traders should never trade without a defined stop loss strategy.