Stop-loss orders are a mechanism that theoretically allows traders to minimize their exposure to loss on a given trade. However, are stop-losses used by professional traders, or are they the realm of newbies and occasional traders?
Some professional traders do use stop-losses. However, most professional traders do not use stop-losses due to the discontinuous nature of price action movements in the markets. Such discontinuity can negate the value of stop-loss orders.
This article will help you understand why some professional traders avoid stop-losses when most literature aimed at the retail trader actively suggest and promote them. If you are uncertain about the value of stop-losses, read on and find out for yourself if they should be part of your trading arsenal.
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Table of Contents
What Is a Stop-Loss Order?
At the most basic level, a stop-loss order is an order to buy or sell a stock when it reaches a specific price. It is intended to provide traders with a level of protection from massive losses if their trade moves against them beyond a certain point. It can be used in both long and short positions.
The Generic Argument in Favor of Stop-Losses
The argument presented in favor of using stop-losses revolves around the protection that they can provide against unexpected losses on open positions. Ideally, when a stock price in a long position drops to a predetermined level, the stop-loss order would be converted into a market order and the position sold at that price. When a short position is involved, the stock is bought at a predetermined price.
In both cases, the desired result is to contain a potential loss to a specific amount.
Why Do Some Professional Traders Avoid Stop-Losses?
While, in theory, stop-loss orders would appear to be an effective way to curtail losses when a trade goes against a trader, the reality of the situation can be different.
This disconnect from the theoretical value of stop-loss orders and their practical application is what most professional traders cite when not using them. Some of the reasons for not using them include the following.
The Disorderly Nature of Price Action in Markets
Financial markets are not orderly. On any given day, price swings can occur within very narrow timeframes. Rational, as well as irrational forces, may cause these price movements.
It is not uncommon for a security to plunge below your stop-loss, triggering it, only to recover quickly afterward. Some large institutional traders and trading algorithms take advantage of these situations. Such activity is colloquially known as stop hunting. By breaking up their larger orders, they can effectively push the market to take out the stops and clear liquidity in a beneficial direction.
Unfortunately, this means that if you had a stop-loss in place—especially if it was tight—your position might get closed even though the price action for the security soon resumes the path that you had initially envisioned.
Flash Crashes
Flash crashes are rapid and highly exacerbated declines in the price of a specific stock or across a market in general. Flash crashes are not a common occurrence, but they do occur.
When they do occur, the presence of stop-loss orders can create a loss on a scale not anticipated by a trader. The very nature of a flash crash would result in triggering the market order to sell, but with a rapidly plunging market, the order would likely get filled at a price way below the original target price.
By the time the flash crash corrects itself, even if it’s only minutes later, the fact that the stop-loss was triggered would leave the trader with a hefty loss.
Slippage Can Cause Losses Greater Than Anticipated
Trading during intensely volatile markets or trading securities with very low volume can create slippage between the stop-loss price entered by a trader and the actual market price that it is filled at when triggered.
Imagine a position with a stop-loss set at $10.00. However, due to market sentiment, when the stop-loss is triggered, there are no bids at $10.00. The order would then be filled at the first available bid, even if this is much lower than the original trigger price.
Even those professional traders who do use stop-losses tend to avoid having them in place when low trading volumes are involved or when major news on a specific stock or the financial markets is imminent. They do so because even securities that are not as prone to slippage are more susceptible to it during those moments.
Stop-Losses Are Not as Essential When Hedging
Professional traders are likely to hedge their trades. They are essentially offsetting the risk present in one trade with another trade that has a negative correlation. It is a risk management strategy that can negate the need for stop-losses since hedging offers quasi-insurance against a loss.
If the original trade moves against the trader, the hedge should compensate for all or part of the loss.
It allows traders more control in when to trigger them and allows for more rational application. It permits the trader a particular safety net without handcuffing them to automatic reactionary responses, unlike stop-loss orders.
Less Leverage Makes Stop-Losses Less Necessary
Using leverage in trading will increase your profits, but it will also magnify your losses. This potential for heightened loss is what is often used as an argument for having to use stop-loss orders.
Professional traders do use leverage. However, they tend to do so more sparingly and with greater strategic forethought than retail traders. As such, the need for tight stop losses is not as present with a professional trader using 2-to-1 leverage versus a newbie forex trader using 50-to-1 leverage.
By being minimally leveraged or not leveraged at all, professional traders have more latitude in seeing their trade hypothesis through to the end without having to worry about how small downturns could impact their overall position. It also permits them to use other techniques to protect against losses, such as the hedging strategies that were previously mentioned.
Depends on Your Trading Timeframe
There are three primary timeframes for trading. From shortest to longest, these are day trading, swing trading, and position trading.
Day trading involves getting in and out of positions intraday. By the time the markets have closed, a day trader will, in theory, be in an all-cash position. Conversely, swing and position trading involve holding on to trades for periods of one day to a month and more than one month, respectively.
Due to the very narrow timeframes that day traders must trade at and the keen attention they must place on risk mitigation, stop-loss orders in day trading are common. An argument can be made that they are a necessity.
While there are many day trading strategies, most agree on limiting your exposure to no more than one percent of your trading capital per trade. As such, tighter adherence to risk/reward ratios is required. Stop-losses play an essential role in this regard for day traders.
However, the risk mitigation potential using stop-losses in is not as prevalent when longer trading time frames are involved. Therefore, the timeframe of a professional trader’s trading strategy can greatly vary their adherence to stop-losses.
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Conclusion
Some professional traders do use stop-loss orders. The overriding conviction among the professionals, however, is to use them sparingly and cautiously. The very nature of the financial markets, price action swings, the potential for flash crashes, and disparities in the fill price versus the target price create potential scenarios that would make using stop-losses more detrimental than beneficial to a professional trader.
However, there are also scenarios, such as professional day trading, where the tight timeframes and risk/reward ratios practically require stop-losses.
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