Can Stop Loss fail?

Many traders employ a stop loss to protect themselves from losing a large amount of money or all of their capital on a deal. After all, it is often regarded as an essential component of any trading strategy. Do stop losses, on the other hand, always work?

Stop losses do not function in every situation. They manage to avoid large losses under regular market situations, but they are far from impregnable. Market lockdowns, very low liquidity, and market gaps against you are all instances of situations where putting a stop loss will be useless.

Why Use a Stop Loss?

A stop loss is used to guarantee that losses do not get too large. While this may appear to be self-evident, there is a bit more to it than you may believe at first.

Consider two traders that use the identical trading method but differ only in the amount of their positions. As a result, trader 1 will employ a stop loss equal to 10% of his entire account balance, whereas trader 2 will use a stop loss equal to 2% of his total account balance.

Both employ a trading approach in which the only two conceivable outcomes are a profit or a loss. To put it another way, the technique employs a profit objective as well as a stop loss to quit the trade.

Assume that both traders have a 10-trade losing streak. While trader 2 will be left with a 20% loss after just risking 2% every transaction, trader 1 will have entirely wiped out his account!

Even with far lesser drawdowns than 100%, you may have had a loss so large that you are unable to recover. Making a 50% loss, for example, would need a spectacular 100% return simply to get back to breakeven.

While this may seem acceptable at first, as you approach the 50-70 percent drawdown zone, you'll find that the returns required to breakeven increase dramatically. To make up for the money you've lost, you'll have to accomplish returns of several hundred, or perhaps thousand percent at some time!

Stop losses, in other words, reduce the chance of incurring irreversible losses and seek to safeguard your trading cash.

How big should the stop loss be?

Most stop loss size recommendations are in the range of 1-3 percent of the overall account balance. This guarantees that you can weather extended losing streaks without losing all of your money.

Striking a balance between risk and return is one of the most difficult jobs every trader has. If you take too many risks, you may lose all of your money. On the other hand, if you take too little risk, you can discover that the rewards aren't worth it when you consider the time and work involved.

Why Don’t Stop Losses Work All the Time?

Stop losses are valuable tools that you should employ, but they aren't foolproof. There are times when a stop-loss order is placed but does not go through, leaving you with losses greater than your stop-loss amount.

One of the reasons why some individuals choose day trading is that they do not want to risk their money overnight. They're particularly concerned about overnight gaps, which occur when the market closes at one price and opens at another. This might result in the market blowing over your stop loss level without you being stopped out if you're unlucky. Then, as soon as the market opens, you'll exit the transaction, but at a considerably higher cost.

Even while overnight gaps might be risky, it's crucial to remember that the stock market generates the majority of its profits overnight. In other words, you are compensated for taking the extra risk of holding transactions overnight!

Poor Liquidity

Since a stop-loss order simply issues a market order as soon as the stop loss level has been hit, it’s critical that there is enough liquidity in the market for the transaction to take place.



In case there is too little liquidity, you may experience significant amounts of slippage, which basically means that your trade is filled at a much worse price, since there was no one there to take the other side of the trade.



Even though this usually happens in markets with very low liquidity, it may also happen in more liquid markets, if there is an explosion in market volatility. When there are sharp moves in the markets, you usually experience more slippage.

Because a stop-loss order merely places a market order whenever the stop-loss threshold is reached, sufficient liquidity in the market is required for the transaction to take place.

If there is insufficient liquidity, you may encounter severe slippage, which simply means that your trade is filled at a considerably lower price since no one is willing to take the opposite side of the deal.

Even though this is most common in markets with very little liquidity, it can also happen in more liquid markets if market volatility spikes. When the markets make big changes, there's generally a lot more slippage.

Trading Halts

In the worst-case situation, trading halts can last anywhere from a few minutes to many hours, or even days. Being locked in a position when the market closes down is a nightmare for a trader since you have no idea when trading will resume or what price the market will open at

Mean reversion strategies

Stop losses don't function well with some trading methods, such as mean reversion strategies. Mean reversion techniques attempt to catch the falling market in anticipation of a turnaround by detecting oversold circumstances. When a result, as a market falls, the edge grows bigger, which implies a stop-loss would get you out of the trade when it's at its most profitable stage.

Because of this, stop losses are rarely used in swing trading techniques. Instead, we just use a tiny amount of our trading money to trade such tactics. As a result, no lost deal will have a significant impact on the account. This strategy is achievable because to algorithmic trading, which allows us to trade many strategies at the same time.

As you can see, stop losses are far from foolproof. This is critical to understand, especially if you trade with high leverage, as large holdings combined with large swings can be dangerous!

Alternatives to Stop Losses

If you don't want to utilize a stop loss and instead prefer to employ alternative strategies to limit the danger of losing your money, here are some things to think about

Only Trade Liquid Markets

If you choose markets with minimal liquidity, there's a good possibility you won't be able to get out of a position at a fair price if something goes wrong. Keeping this in mind, it's best to stick with companies and markets that have a lot of trading activity to back up orders, even in volatile markets..

Position size

Keep in mind that the amount of your holdings will affect your trading account's total risk level. With larger positions, the final losses will also be larger. Make sure that no single position accounts for too much of your overall account balance!

Trade many Markets

When you trade many markets, it's more probable that at least some of your deals will succeed and compensate for the ones that don't.

Stop losses are excellent instruments for limiting downside risk in trading. They should be utilized almost all of the time. However, it's critical to understand that a stop loss isn't a foolproof solution that will suddenly eliminate all of the hazards associated with maintaining a market position. You could, for example, find yourself in a scenario where the market gapes against you, rendering the stop loss almost meaningless.

There are, however, alternative strategies to reduce the risks associated with keeping a market position. These include diversification across many markets, trading only liquid marketplaces, and ensuring that the amount of each individual position does not exceed the account size.