The Truth About Setting Stops
You may have heard some conflicting information about setting stop losses, and be wondering what to do. Some people say to always set them, others say never do that, and sometimes you’re supposed to figure out for yourself if you need stop losses set.
Why You Need Stops
The reason to set them goes back to the idea that you can lose too much if you rely on your own discretion in the heat of the moment. This is a very real concern, as when you have just decided on a trade, taking however much time and care your trading system requires, it is very difficult to turn around and say straight away that you have to sell for a loss.
It feels like you have failed, and that is something that as humans we all try to avoid. Nonetheless, it is the ability to cut your losses quickly that is one of the keys to successful trading.
So if you can set an order in advance to close out the losing trade, then forget it, not worrying about any emotional feeling, for what reason would you not do this? There are several.
Why You Might Not Set Stops
Firstly, for a thinly traded stock, there can be genuine large fluctuations in the price, and you may have made a good selection that suffers a spike which takes you out of an otherwise winning trade. If you have the benefit of what is called a Level II screen, you can see that it may not be misfortune alone that causes this.
A Level II screen shows the pending orders. There’s a buyers’ column and a sellers’ column, showing the stop and limit orders in place that are awaiting execution, if the price was to rise or fall to the required level. For instance, the buyers’ side might show on the top an order to buy 1000 shares at $1.63, and the sellers’ side might show that someone else is prepared to sell 5000 shares at $1.64. The columns are sorted so that the orders nearest to being fulfilled are at the top – there will be other pending buyers who want to pay less, and sellers who want to get more.
No trade can take place on the shares as described. It needs one of the existing parties to change their minds on what price they are happy with, or someone new coming in with a price that works, or a market order, to make the next trade happen.
Now if you are a big enough trader, particularly with a thinly traded stock, what you do can influence the prices. Hit the market with a big order to buy, and the price will go up, as each seller’s price must be reached to get the shares. Or by selling, you can reduce the price for the moment. So by manipulating the prices, you can force a stop loss to be triggered, and you know exactly how much you need to do this by looking at the Level II screen. If you are convinced that the stocks are going up, as is our hapless trader who has their stop loss order on the market, you can make the price go down to pick up his shares, and then you benefit from the subsequent rise in value, while the trader is left without any shares, but seeing that he was proved right in the end.
That is one way you can lose by the simple action of putting your stop loss order on the market. There are more nefarious ways too. Contracts for Difference aren’t permitted by the Securities and Exchange Commission in the US, but are available in many other countries worldwide, and they seem to be particularly prone to fiddling. The CFD broker will often be a market maker, which means that they write their own price for the deal. It tends to follow the market, of course, but certainly there are times when it can be demonstrated that an unexplained blip in that broker’s chart, that didn’t occur in any other, took out some stop loss orders.
Contracts for Difference, which work on margin so you do not have to pay the full share price, give you the difference between the price when you take them out and the price when you close the trade. This can be profit or loss, depending on the share price move. The CFD broker gets his profit from a spread between the price for selling and for buying, and in theory hedges his position by buying the underlying shares, so he is neutral with respect to the trader. Too often it seems this does not happen, effectively meaning that the broker is betting against his client – and one way out of this is to spike the prices to trigger the loss for the trader.
Of course, not all CFD brokers are dishonest, and you can now also access CFDs traded on an exchange, which keeps the prices in line and not manipulated. But it is another way that placing a stop loss order on the market can work against you.
If you are in the US, you may be thinking that this couldn’t happen to you as you can’t buy CFDs. But the broker making the market is also a common practice in the Forex world, so you still should not feel safe in this market. To be sure you avoid the possibility of stop loss hunting by the broker spiking the price, you need to look for a broker who offers an ECN, which is short for electronic communication network. This gives you direct market prices.