Traders who have traded long enough would have experienced losses that were bigger than initially intended. The worst cases are seeing entire trading account value go to zero. Yours truly have experienced that before. I was doubling a position that was going against me because I refused to admit that I was wrong. As a result, I blew up a $100,000 account just like that and it was a painful lesson.
The most cost-effective approach is to learn from the mistakes of others. Conversely, the more expensive route involves learning from our own costly errors. If I can offer a lesson to you, it is to remember that the market is much bigger than anyone and it is futile to believe that we are right and the market is wrong. Never bet against the market. In other words, traders need to stay humble and know that we are fallible and cut our positions so as to protect our capital. This is simply because we can’t trade when our capital is gone. Thus, one of the most crucial mantra in trading is to cut losses timely and an effective way to do it is to use stop orders.
How to know when to cut loss?
There are many ways to determine your cut loss levels.
One approach is to identify key support or resistance areas where if price breaks through, a potential significant downtrend or uptrend may ensue that will result in huge losses. Traders may use historical price ranges, trendlines or moving averages to determine these stop loss levels.
Another method to determine appropriate cut loss levels is by customizing them according to the volatility of the stock. One useful indicator for this purpose is the Average True Range (ATR). The ATR measures the historical price movements’ volatility, and its value increases or decreases as volatility expands or contracts, respectively. By considering the ATR, traders can set more suitable stop loss levels that accommodate the price swings without prematurely exiting their positions.
A practical application of this approach involves using a multiple of the ATR value. For instance, if you have a long position in a stock, you can set a stop loss at 2 times the ATR value below your buy price. Conversely, if you have a short position, you can set the stop loss at 2 times the ATR value above your sell price. This strategy allows enough leeway for the price to fluctuate while ensuring that if the price reaches the stop loss level, it signifies that a strong reverse trend is underway. It would hence be prudent to exit the trade promptly to avoid further losses.
Regardless of the approach you choose, it is essential to have a clear exit plan for each trade you undertake. Leaving things to chance or postponing the decision to determine your exit shows a disregard for risk management.
What is a stop order?
Once you have identified your cut loss levels, it is important to place stop orders for your positions. While many traders are familiar with market and limit orders, these types of orders may not be suitable for cutting losses effectively.
Let’s consider an example to illustrate this point. Suppose the current share price is $10, and you want to cut your losses if the price drops below $9. If you were to set a sell limit order at $9, the order would be executed immediately at the prevailing market price of $10, since a limit order always fills at a better price than the set limit.
A stop order, on the other hand, remains inactive until the price reaches a specific predetermined level, at which point it becomes a market order. Continuing with the example, setting a stop order at $9 means that the order will not be triggered until the share price drops to $9, at which point it will be filled at the prevailing market price.
In essence, a stop order executes your cut loss plan effectively by activating only when the price reaches the specified level, protecting your capital and managing risk accordingly. With the IG trading platform, traders can indicate their stop loss levels on the trade or order ticket together with their entry. The stop loss can also be amended in a live position.
You need to honor your stop losses
Although I have harped about the importance of stop losses, some traders may still not adhere to their stop loss levels. This behavior can be attributed to several reasons.
Firstly, some traders may become overly confident that the market prices will bounce back in their favor, despite evidence suggesting otherwise. Unfortunately, this optimism can prove to be misguided, resulting in even greater losses.
Secondly, nobody likes to see losses on their trades, and it is natural to hope that the market will turn around and erase those losses. However, such loss aversion bias can be detrimental to long-term trading results. I have been there.
While it can be frustrating to have taken a loss only to witness the prices recover in your favor later on, it is crucial for you to adopt a different perspective. Instead, you should consider the potential consequences of not cutting your losses and allowing them to grow even larger. In such a scenario, the impact on your trading account and emotional well-being could be far more severe.
When you exit a losing trade by honoring your stop loss, you not only preserve your capital but also clear your headspace. This mental clarity allows you to focus on finding the next trading opportunity, reducing the opportunity cost of holding onto unprofitable positions for extended periods.
Thus, place your stop orders and honor them.
How to guarantee your stop orders with knock-outs
One effective way to ensure traders honor their stop losses is through the use of knock-outs. Knock-outs are a unique type of CFDs (Contracts for Difference) that come with a distinctive feature – an obligatory stop loss requirement that cannot be removed once the trade is initiated.
With knock-outs, traders are compelled to set a stop loss at the beginning of the trade, and this stop loss level remains fixed even if market prices experience significant gaps. This feature provides an additional benefit, as it protects traders from unexpected price gaps that might otherwise lead to more substantial losses.
To illustrate, let’s say you set a stop loss order at $5 for a particular trade. By trading knock-outs, If the price of the asset suddenly gaps down to $4, the stop loss will still be filled at $5, preventing you from incurring a loss greater than what you initially intended. On the other hand, if you used a regular stop order, you will be filled at the market price of $4, resulting in a larger loss.
Knock-outs offer a valuable risk management tool that enforces the discipline of honoring stop losses as well as limiting losses to the pre-determined levels, no matter how volatile the market becomes. With this unique feature, you can better safeguard their trading capital and maintain a more responsible approach to your trading.
Knock-outs are exclusively available through IG Markets.
You can easily trade knock-outs directly on IG’s trading app or web platform if you have an account with them. Here’s how to set it up: Knock-outs
Pros and Cons of Knock-outs
Trade a wide range of assets with one account: A key benefit of knock-outs is their versatility in trading a wide range of financial assets. You can use knock-outs on various underlying instruments, such as indices, shares, forex, and commodities. This diversity provides ample opportunities to explore different markets and trade multiple kinds of assets, all within the convenience of a single trading account. Moreover, IG Markets‘ commission-free policy for FX, indices, and commodities further enhances the cost-effectiveness for traders, allowing them to capitalize on various opportunities without incurring additional fees.
Leverage: Knock-outs are leveraged products, meaning that they allow you to control larger positions with a relatively smaller amount of capital. This amplifies both potential gains and losses. While the increased leverage can be advantageous when making profitable trades, it also implies that losses can be more substantial. You must exercise caution and have a clear risk management strategy in place when using leveraged products like knock-outs.
Expiry dates: Knock-outs come with an expiry date, which is typically in August each year where your trades will be automatically closed. However, you have the flexibility to close your positions before the expiry date if you want to exit a trade earlier. As such, knock-outs are not meant for long-term holding. You should only use knock-outs when you have reasonable confidence for certain price movements within a short timeframe.
Double stop loss: Knock-outs provide a unique double stop loss feature that includes guaranteed stop loss and a normal stop loss. The guaranteed stop loss is designed to safeguard against price gaps and requires a small premium to activate. However, the notable advantage is that if the normal stop loss is triggered, the premium paid for the guaranteed stop loss will be refunded. This combination of stop loss mechanisms provide greater flexibility to control risk.
IG’s Pricing and Spreads: Knock-out prices are quoted by IG and quoted at exactly (1 to 1) to the underlying CFD product. Example: US500 CFD vs US500 KO CFD have the same bid and offer. The price quotes are generally competitive and there is no further markup in terms of spread when trading knock-outs. An added benefit is that the spreads are factored into IG’s pricing, making it easier for traders to calculate their stop levels, potential profits, and potential losses accurately.
Risk management and psychology are two of the three ingredients of a profitable trader
To become a profitable trader, three essential elements come into play. In this article, we have covered two of them, namely risk management, which includes having stop losses in place, and the psychological aspect of honoring these stop losses. The third element, a trading system with a consistent edge, will be discussed separately in the future.
One common challenge that some traders face is their struggle to adhere to stop losses. This is where knock-outs can be a true lifesaver. By using knock-outs, traders are compelled to stay committed to their trade plan since they cannot back out or remove the stop loss once the trade is initiated. This mandatory feature ensures that traders remain disciplined and focused on their trading strategies, preventing emotional decision-making that may lead to detrimental consequences.
In addition to instilling discipline, knock-outs also protects traders from market gaps and helps prevent them with more losses past the knock-out level. Normal stop loss will be triggered in normal market conditions, while guaranteed stop loss (knock-out level) will kick in to prevent traders from losing past the knock-out level in the event that the underlying market gaps.
Due to their expiration date, which usually occurs in August each year, knock-outs are more suitable for short-term trading rather than long-term investing. To utilize knock-outs effectively, traders should possess a solid understanding of their trading system and the ability to project price directions within the designated timeframe with a proven edge.
Get S$288 and earn 5,000 KrisFlyer miles when you open an account with IG, make a one-time deposit of at least S$5,000 and place at least one trade by 31 Oct 2023*
* See full Terms & Conditions. CFD losses can exceed deposits. Refer to Risk Disclosure Statement and Risk Fact Sheet at IG.com/sg. Issued by IG Asia Pte Ltd (Co. Reg. No. 200510021K).
Disclaimer
IG provides an execution-only service. The information in this article is for informational and educational purposes only and does not constitute (and should not be construed as containing) any form of financial or investment advice or an investment recommendation or an offer of or solicitation to invest or transact in any financial instrument. Nor does the information take into account the investment objective, financial situation, or particular need of any person. Where in doubt, you should seek advice from an independent financial adviser regarding the suitability of your investment, under a separate arrangement, as you deem fit.
No responsibility is accepted by IG for any loss or damage arising in any way (including due to negligence) from anyone acting or refraining from acting as a result of the information. All forms of investment carry risks. Trading in leveraged products, such as CFDs, carries risks and may not be suitable for everyone. Losses can exceed deposits.
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