Stop-loss orders are widely used tools in trading that allow investors to limit their potential losses by setting a predetermined level and when this level would be reached their securities will send a MARKET ORDER to be sold. Yes, MARKET ORDER is what the STOP LOSS order activates.
The logic is quite simple and if your broker cannot explain this concept in a clear way probably has an interest that you misuse and do not understand before is too late the effectiveness of STOP LOSS (SL) orders.
Let’s make an example first. If you hold a financial instrument, regardless is a future, an option, a CFDs or simply a cash equity, you can place a SL order and this order MUST be below current market price. Thus your position can be either on gain or at loss , it is not mandatory to carry a losing position to place a STOP LOSS order.
While in theory SL orders can serve as an essential risk management strategy, they also carry with them a sense of false security. Here are several reasons why:
1. Gaps in Price: STOP LOSS orders only guarantee execution, not the price at which the trade will be executed. In fast-moving markets, a stock price can ‘gap down’ (or up), skipping past the stop price, resulting in an execution far below (or above) the intended stop price. This scenario is especially common with volatile stocks, during earnings reports, or when significant news about a company or the economy is announced overnight.
2. No Protection Against Volatility: In the world of trading, volatility is inevitable. While a STOP LOSS can protect against downside risk, it also runs the risk of being triggered by temporary price fluctuations, resulting in selling out of a position just before the price recovers. This is often termed as being “stopped out.”
3. Emotional Decision Making: Having a STOP LOSS in place can sometimes lead to complacency and a lack of continued research and analysis. Traders may also become over-reliant on stop-loss orders, neglecting other crucial aspects of trading like fundamentals or sentiment analysis. This over-reliance can lead to emotional decision-making, which is typically detrimental to trading performance.
4. Market Manipulation: In less liquid markets, STOP LOSS orders can sometimes be visible to other market participants or brokers, who may manipulate the market price to trigger the stop level. While regulatory bodies try to prevent such activities, they do happen, posing another potential risk to using STOP LOSS orders.
5. False Sense of Security: The most significant risk of all is the false sense of security that STOP LOSS orders can provide. They are not foolproof, and while they can help manage risk, they cannot eliminate it entirely. Traders must always remain mindful of the inherent risks of investing and not become complacent merely because they have a stop-loss order in place.
Thus if you are afraid of gaps, either intraday or more likely on openings, is a signal that perhaps you are not comfortable with the position. Better to reconsider the portflolio and de-risk with a lower exposure.
Too tight stop losses can be triggered easily thus eliminating any possibility for the position to express the underlying strategy and SL too close current prices are justified by leverage and margin, perhaps is another valid reason to reconsider the rationale of the position itself.
Liquidity providers can see the whole book and in certain jurisdictions especially on OTC products (derivatives over the counter) , stop loss hunting is a very profitable activity for certain operators.
The misunderstanding of SL can add debt beyond what one expects, emotional stress just after a prolonged sense of false security.
In conclusion, Stop-Loss orders can be a valuable risk management tool for traders, but they should be used wisely and should not replace careful analysis and risk assessment. Rather, they should be one part of a comprehensive trading strategy that includes proper diversification, portfolio rebalancing, and an understanding of the risk tolerance level.
