Stop Loss - A Fraud By The Smart Money

What Is A Stop Loss?

In its most basic form, a stop loss is like a parachute, but not the one used by skydiving junkies, more like the ones kept in private jets should an emergency present itself...


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I could never understand the skydiving daredevils, I can appreciate the thrill in it, but relying on a single parachute, never really made sense to me. Using stop loss in your trading us much like banking on a parachute everytime you jump out of a plane. The risks are just too high should it fail, and this is what happens with the majority of retail traders who take the well-meaning advice of always placing a stop loss...

There Is More To Stop-loss Than Meets The Eye

Hell, I will go one step ahead and call out the fraud called stop-loss purported by people who claim to be your well-wishers. I know this may be a very bold statement and one that will annoy many, but I must share what I have learnt over the years about this.

So how exactly is putting stop-loss detrimental to your trading? Well, the biggest concern for the majority of traders, regarding their stop loss, is that it may get hit. That is a legitimate fear because it will get hit more often than not because smart traders are banking on it.

In fact, smart traders have a detailed plan of action a well thought out strategy to exploit stop loss orders put in by retail traders, its called the "stop hunt"! Heard of it, even if you have not if you are trading for a while, you surely have experienced it. I was on the wrong side of it for a big chunk of my trading career...

So how do we spot this stop hunt before it happens and how do we deal with this problem with a stop loss in general? Read on...

Basics Of Stop Loss

Before I go on to present my case I must cover some of the basics of stop loss. You need to understand the terminology to understand the bigger picture here.

• Entry Price - It is the price at which you enter a trade or plan to enter a trade.
• Exit Price - It is the price at which you exit a trade or plan to exit a trade.
• Capital - It is the amount of money in your trading account.
• Risk Per Trade - It is the amount of money you are prepared to lose on a single trade.
• Total Risk - It is the amount of money you are prepared to lose in a day, week, month, etc.

Now using these parameters we can explain the stop loss mechanism in greater detail. Assume yourself in the following situation...

You have a bullish view on the markets. You do your research and believe that stock xyz is ripe for an up move. You find a nice technical setup developing on the xyz stock and decide to enter the trade. But suddenly you feel a chill, what if this trade does not work out? What if the stock does not move up? That is when you remember to put in a stop loss, as learnt from your technical analysis course, heard on the news channels and on the internet. Afterall they are trying to help you protect your capital, aren't they? It looks something like this...

Now to put in a stop loss you need to know...

• Trigger Price - It is the price level (counter to your trade direction), which when reached you will get out of the trade and book your losses.
• Execution Price - It is the actual price at which your stop loss order gets executed.
• Stop Market Order - Most commonly used type, where when you stop loss trigger price is reached a market order is sent to the exchange to get you out of your position.
• Limit Stop Order - Used by experienced traders, when your stop loss trigger price is reached a limit order is sent to the exchange to get you out of your position.

So you go ahead and set your trigger price for the stop loss order.

What Happens Next

Once you have put the stop loss order, there is nothing much left for you to do. You monitor the markets, if they move in your favour you may decide to take profits at a certain target level or when markets start losing momentum or you preferred exit criteria (this is not the place to discuss that).

But should the market move contrary to your expectations (get used to it, happens more often than not) your stop loss comes into play. If it moves down enough to hit your trigger price, then the stop loss order is sent to exchange and gets executed.

You are out of your position with a small loss, ready to take on the markets once again, with a fresh set of analysis. Sounds familiar sure has happened to me a lot, still happens. Everyone has a funny stop loss story, if you have one and care to share, use the comments section below...

How Stop Loss Works?

Now the above scenario is very common and is widely accepted by traders, retail ones especially. So what is wrong with it? Where is the catch?

Ask yourself this question, what is the most likely place you might want to put a stop loss?

• A recent swing high or low.
• At recent support or resistance.
• Beyond recent support or resistance (the wise ones do this, they use a filter).
• A fixed money stop (10, 20, 50 pts), sometimes related to the Average daily range of the stock, aka ATR (1X, 2X, etc of ATR).

Sounds familiar, well in all the above cases what is the logic that says your stop loss will not be hit. I have pondered over this issue a lot and realized that no matter where you put your stop loss it will be hit. Because that is what the smart money is counting on, that is how they acquire great positions, but pushing you out of good ones.

When your stop loss is getting hit, there are smart traders on the other side of the trade accumulating all the inventory. They were tracking your activity all along.

Look at this example...

You buy stock xyz at INR 250 and put your stop loss at one of the following levels,

• Recent swing low - which was at 230.
• Recent support - which was at 225.
• Beyond recent support - at 220.
• ATR stop - a 2ATR stop at 235 (let's say ATR is 7.5 for xyz)

Now there are many traders who though in a similar fashion and have put a stop loss in the zone from 220-235. In this 15 point zone, a lot of sell stop orders are there, that is if prices go below these levels you and traders like you will sell their positions, lots and lots of them.

Now if the smart money manages to take prices in this zone a cascade of stop orders will hit the markets and might end up taking the price below this 220-235 zone. Lots and lots of stop losses will be hit and a lot of sell orders will hit the markets.

The smart money was waiting for this, they step up and buy all this supply. and then something happens which has caused countless traders serious heartburn, market resumes its uptrend.

This Is How Stop Loss Is A Fraud

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First, you were lead to believe that putting an SL is a good strategy, and then these smart traders are actually feeding on your stop losses to accumulate their inventory. So how do we stop this from happening? Is there a way a retail trader can fight with this?

There sure is and that is where positions sizing or money management comes in.

Correct Positions Sizing And Stop Loss

You need to follow the following steps if you wish to make in the markets...

First - based on your analysis find out a price level where you will be absolutely sure, without a shadow of a doubt that the markets are not going in your intended direction. Either they are going in the opposite direction or consolidating further. But there should not a be any doubt about that.

Second - you calculate based on the maximum risk per trade you are willing to take, how many shares, contracts you can buy. For example...

• You decide to risk INR 1000 per trade.
• The price level where your analysis or view gets invalidates is 50 points away.
• You are allowed to buy 1000/50 = 20 shares.

Third - you place your stop loss at a price level 50 point below your entry price. This level should come from your technical analysis. Should the prices reach this level, you should be absolutely sure that your analysis has failed, and that is alright.

Fourth - you make sure the INR 1000 you are risking is a minuscule percentage of your total trading capital. The higher the risk you take the more volatile your results will be.

Unless your position sizing matches your technical analysis you won't be able to survive in the markets. In the earlier example, had you placed your stop loss at any of well-advertised levels, it would have been hot and you would have lost your money.

First Line Of Defence - Correct position Sizing

Always remember your first line of defence is your position sizing your stop loss comes beyond that. If your maximum risk or in other words the maximum amount that you can lose lies beyond the invalidation point of your trade, you have a chance to survive in this highly competitive game.

Conclusion

The only way you can make it in the markets is by sizing your positions such that no single trade is a threat to your account. Along with that, you need to put your stop loss at levels which will make it absolutely clear that your trade idea is invalidated. always make sure the position size or consequently the maximum risk you are willing to take includes your invalidation point.

I am sure this is a provocative post, many of your beliefs may contradict with what is stated in this post if it does, it's a good sign, we have something to discuss now. I am eager to hear your thoughts on this one. Also involve as many traders, friends and colleagues in this discussion as possible. So go ahead share this post with your friends and colleagues, because...

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