Stop Losses and Trading Probabilities
In the first part of this stop loss psychology article, we provided an extreme example and perhaps an extreme stock trading scenario (though it does occur every day), but it exposes something important about the use of stop losses. Stop Loss Psychology: Trading is all about probabilities.
If the probabilities are in your favor, you will make more money than you lose over time. If the probabilities are against you, you may win sometimes, but you will eventually empty your trading account.
When you buy a stock like DOC after a big run up, it is almost impossible to put the probabilities in your favor. Why? Because the only stop loss you could possibly take after the stock has already made a run up would be an arbitrary one.
The Key to Proper Stop Loss Psychology Placement
In order to use a stop loss correctly, you need one bit of very important information. This information is “where would the price have to drop below for me to know that something has gone wrong and that sentiment has changed from bullish to bearish?” In other words, you need to know where a breakdown could potentially occur. Go back to the first section of this article and look at DOC’s chart again. It’s just about impossible to determine where a true price breakdown would occur.
As a result, anyone who traded DOC would face an extremely difficult psychological dilemma. Every trader knows that they have to use stop losses so, not knowing where a breakdown could occur, they would just have to pick some arbitrary (or semi arbitrary) price point on the chart and tell themselves to take a loss there. It’s time for some cash budgeting
Why Arbitrary Stop Loss Placement Creates a Psychological Dilemma
What a huge dilemma this is though. We have all faced it. We tell ourselves that if the price drops 2%, 5% or even 10% we will take a loss. Or, we say, if the price breaks the 10 period moving average, I will take a loss. Then, when the price does drop down below our predetermined place on the chart, we don’t take a loss because we reason with ourselves “I don’t want to sell at the bottom, so I’ll wait just a little while longer.” This is where the human psychology that we read about in that trading lesson this week comes into play.
Our contention is, however, that this entire approach has it all wrong.
The Problem, You See, Is Not Human Psychology
That voice inside your head that rationalizes not using a stop loss is the work of your natural human defense mechanism. Any reasonable person would have a hard time rationalizing a sale of a stock they just bought when they know from experience that prices can and usually do reverse quickly. Why would any reasonable person want to risk selling for a loss right before the price jumps back up in their favor? So, the psychological factor we are dealing with here is a natural human defense and it should not be “overcome” by playing silly games such as writing out promises to yourself to sell at certain predetermined junctures. The reason these games don’t work is because it is unnatural for us to tear down our natural human
defenses and reasoning.
The Real Problem Is That Most Traders Just Buy In The Wrong Place
As we have discussed, there is almost no way to put the odds in your favor on a stock like DOC after it has already made a big move. If, however, you decide to only enter where the odds are truly in your favor, then human psychology will be on your side and it will be easy to take a loss.
The Only Stop Loss Psychology Solution that Makes Psychological Sense
In other words, you need to purchase a stock only near where you KNOW that a breakdown would occur if the price closes below that level. If you do this, and the price does move down, it is very easy to take a loss for two reasons. First, the loss you take will be small and not painful. And most importantly, you know that a breakdown has likely occurred so you do not have to worry about selling at the bottom. Instead, you can have confidence that you sold to protect yourself and that the odds favor you. When you do this each and every time, trading becomes easy because it works in favor of your own natural psychological defenses, not against them. And now, instead of it being emotionally difficult to use a stop, it will be emotionally difficult not to.