Stop Losses… More risky than you might think

by Joe Oliver, Forex Trading-Pips

Stop Loss or Not?

Whenever you go to a trading seminar the speakers will invariably highlight the importance of trading with stop loss orders…  ‘never place a trade without a stop protection exit order’. Shortly thereafter follows advice that you should  ‘only take risk / reward trades of at least 3 or 4 times upside versus your downside risk, with stops placed just under / above recent support / resistance’.

While this advice seems sound and even logical, there are some problems…

Problems with Stop Loss Orders

1. A number of  quantitative traders are using sophisticated trading models which actively hunt out stop orders, especially those placed just below or above recent support / resistance. These traders will take out your stops at the earliest possible opportunity.

2. The smaller your stop, the more likely you are to get stopped out. Most trades typically don’t get to 3 or 4 to 1 payoff before first getting stopped out. This leads to multiple losing trades or ‘death by a thousand cuts’ once slippage and commissions are factored in.

Our research shows that stop losses for all but the most robust long term trend following systems hurt trading performance. Indeed over recent years even long term trend following models are showing signs of degradation through stop hunting, central bank market manipulation, government intervention and other forms of electronic trading price manipulation. For more information about electronic price manipulation please refer to the excellent work of Scott Patterson Dark Pools.

Mean reversion strategies are especially vulnerable to stop hunting. It is quite normal to experience adverse excursion on mean reversion trades before they turn a profit. If close stops are used these trades will be stopped out prematurely for a loss.

The most frequent counter argument we hear for using stops is that it is too risky not to use them. Our research shows that stops can actually increase risk, and that risk is far better controlled through position sizing and diversification of equity streams. Our results show that reducing trade size while increasing the number uncorrelated markets, time frames and systems traded creates far superior risk protection than any form of stop loss strategy in today’s increasingly noisy markets.

If you would like to learn more about Stop Loss and Effective Risk Management in the Forex markets today, enroll now in a risk free trial of our Forex Signals Program.