Do you need a mental stop loss in trading?

Advantages of using a mental stop loss?

Using a mental stop loss is one of the favourite solutions of some trading gurus

We can even see this kind of articles in Investopedia with some articles dedicated to this matter. In this case I suppose that the people who write this kind of articles know more about writing than trading, because trading with mental stop losses is a very delicate matter, very delicate.

I am not saying that there are not traders capable of doing that.

For sure there are, but I can say that mental stop losses are not something the majority of traders should use.

The reasons that the experts give are many.

The most obvious and well known of them is that the brokers chase your stops so if you use the mental stop you will not be taken out of a supposed good trade.

This is in part true, but it is something that I think, 99.99% of traders should not worry too much about, and only people who really trade big volume should do.

For the great majority of people who negotiate one or two lots we can be quite sure that we will not find a significant advantage by using mental stops.

If the price has to go down for certain circumstances, then it will go down, independently of the fact that you have a stop loss using the FDAX or not.

If you usually trade 1 or 10 contracts in the DAX or S&P500 I do not think you should be worried about dealers chasing your stops.

The DAX future, for instance, will follow the price of the cash index and that is more important that any “stop chasing” boogie men.

In other words what you have to do is to trade well.

Problems with mental stop losses

In an investopedia article we see the following:

“There is an advantage to not having a fixed stop. One common frustration for traders is setting a stop level, then having that stop order triggered (and the position exited) only to see the stock quickly move back in their direction. This can be avoided by using a soft stop”.

Here we can see one of the big problems of the world of trading.

In this case it is related to the psychology of trading and the term “hope”.

When a trader thinks that a trade is “good”, “has potential”, “is promising”, etcetera, when the trade is showing a loss, then we are in very dangerous territory.

Let me tell you something:

The price is never wrong.

This is one of the fundamental rules of trading.

The price is where it is and that is it.

As traders say since immemorial times:

“Do not argue with the tape”.

Trying to overcome that fundamental rule of trading is a sure road to catastrophe.

It does not matter how good an asset looks.

If the price goes against us, that asset is telling us that it is not the right moment to trade. The best thing we can do in a moment like that is to get out of the market.

In the case of using fixed stops there is no problem: we simple get out of the trade when the price reaches that point.

When you have a “mental stop” then you enter the world of trading psychology and “what if”.

You may think: “this is just a technical correction and the market will soon turn and go back to our favour”.

That is something many have done, including me.

The problem is that the market never guarantees anything to anybody.

If you start doubting, that is the worst moment you can encounter. Because from a moment of doubt to a complete disaster it can take a matter of seconds.

Maybe you go to the toilet and in 5 minutes the asset falls 10%.

Well, if you have a fixed stop loss you might have closed the trade before.

In the case of futures, CFDs, Forex or derivatives you can face a total catastrophe due to leverage.

How to solve the problem of stop loss orders?

In an interesting article of investingshortcuts.com the author says that the mental stop losses are the best solution to become a good trader.

The article gives us some glimpses of how to implement those stops, with some conditions, like the way in which the asset falls, the volume, the “news”.

That sounds very good but as you may see it is not a system we can implement objectively.

How to determine if the news around it are “soft” enough to be able to enter or not in the trade?

How to determine if the volume reached is the adequate or not?

That is easier said than done.

When you are in the situation in which the price of your asset is around the stop you have initially put in your mind it is really difficult to thing with a cold mind, trust me.

However, simply imagine we are able to thing with “cold blood”.

Even so, I can assure you that it is possible that even in that way we cannot escape a catastrophe for a simple reason: the markets change overtime, in other words: the markets form different patterns after some time.

It is possible that by using that combination of factors – volume, news and “fall” – we are able to do some good trades, but what if one next bad trade destroys our account completely just because we “thought it had potential”.

In the article of the web mentioned above, there is an analysis of a trade done in the stock MEETME, a small stock of the American market, I believe.

Well, the article describes to us how the trade was done and that at the end it avoided exiting the trade because the “conditions” had been met and therefore the likelihood of the trade ending up well were high.

Therefore the trader kept the trade even though it was trading below its initial “mental stop”.

What happens is that later the stock fell again and eventually that trade ended up in a loss.

As we see, no matter what the trader did, the operation would be a failure.

Not getting out of the trade when the price was wondering around the “stop loss” was very dangerous.

However, that is something Jesse Livermore would better not do. When his trades were showing him a loss he used to get out. When he did not follow that rule he would end up going bankrupt.

The problem is that many traders try to do something similar, holding onto trades that show them a loss just because they think they will turn around eventually.

Many times, those trades never turn around.

stop mental trading
We buy the stok at 7.76 and put our mental stop at 7.40
Our mental stop is “reached” but I hold onto the trade because I have hope

 

Next day the stock falls 20% and we have a major loss that we could have avoided by getting out the day before

As we can see in the charts, if we followed a similar logic that the one exposed by the web mentioned some months before the original trade, we could have found ourselves in a very complicated situation.

There is no way we can now when the market is going to break down at some point.

A recent example is that of the EURJPY when it fell dramatically in summer of 2016 or the pound when the “Brexit”.

Buying the EURJPY at 118.50 and placing a mental stop order at 118
Imagine you decided to hold onto the trade when it was trading near 118 because you thought it had potential. Imagine you were leveraged 5 or 10:1

In the case of the yen, it was a brutal drop that drove the price down more than 1,000 pips in a few hours.

For sure many traders who were using mental stop losses were caught in that trap.

Just imagine you are a trader using a similar strategy of “mental stop loss”.

You buy at 188.50 and apply a stop at 118.

Some hours later the price is trading at 120 and you are very happy.

Perhaps you are thinking in closing the trade with a good profit.

However, after a few hours the market starts to fall.

The price goes to 119.

You decide to go out for a walk and when you come back you find out that the price has fallen to 118.

With some sort of mental paralysis you are incapable of closing the trade because you think that the market is down just temporarily.

Unfortunately the market completely collapses and the EURJPY falls 800 pips putting the price to 110.

In that moment you are facing a terrible loss, which depending on your leverage can be very significant. Imagine easily a 25% of your account.

In a moment like that you end up losing your mind and closing the trade at a major loss.

All of this because you had “hope”.

You thought you were the king of the world.

Hope and stop losses

In some way stop losses exist to fight hope, one of the most fundamental enemies of the trader.

Many traders try to stick to their emotions, like “hope” and forget their true friend: the price.

The price does not lie.

It is the fundamental judge of the markets.

If you are going to use mental stop losses you had better get out as soon as the price reaches that stop loss level.

Do not ever think for a second.

Simply get out of the trade.

That is easy to say and very difficult to do, even for veteran and professional traders.

When you are trading it is better not to even think that you are going to think.

The best thing you can do is to act.

That is the good feature about fixed stop losses: they do not think.

We will always have the damming slippages, but that is a minor evil.

This issue of stop losses is very important for short term traders, whether they are scalping or doing trades that last many days.

Remember this: a trade is not good if it is quoting near a “mental stop loss”.

It means that the trade is not good.

Some other trade in the future could be good, but not that one.

Be careful with that theme of stop losses and hope.

The world of trading is a very complicated one.

Regards and good trading.

Original article: ¿Necesitas usar stop loss mental en trading?

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