Understanding stop loss psychology. That voice inside your head that rationalizes not using a stop loss is the work of your natural human defense mechanism
When you use disciplined stops each and every time, trading becomes easier because it works in favor of your own natural psychological defenses, not against them
Instead of it being emotionally difficult to use a stop, it will be emotionally difficult not to.
Traditional Stop Loss Psychology Use and Mind-Numbing Platitudes
Years ago, a trading organization, which we won’t name, sent us a trading lesson dealing with the use of stop losses. Always ready to learn something from another perspective, we read eagerly hoping to see a new idea or two. Unfortunately, we were disappointed to find the same worn out cautionary tales of traders who lose money because they fail to stop out of their trades at the predetermined price.
The article then went on to suggest that the problem is one of human psychology. The suggested solution was to train stock trading pupils by repetition, asking the readers to write out a statement before each trade “I promise to take a loss if the price reaches XYZ. If I fail to take a loss, then I promise to take half a loss if the price reaches YZ. If I fail to take a loss at YZ, then I will quit trading.”
Common Misunderstandings About the Purpose of a Stop Loss
The trading lesson exposed what we feel is a common misconception about how and why to use a stop loss. As you may have noticed, we have already written pretty extensively on this issue, but we are not convinced the concept has been exhausted yet.
You see the problem with traders not using stop losses has nothing to do with human psychology and everything to do with where they enter a trade.
Before You Buy A Stock, There Must Be a Logical Place to Put a Stop Loss
Traders often write to us and ask us what do we think of various stocks. Many times the stocks we are asked to review are stocks that have just made a huge gain and gathered the attention of the trader community. Usually when we get these questions, we have to say, “yes, that’s a great stock, but where do you plan to buy it and where do you plan to exit?”
You Have to Have a Rational Exit Strategy Before You Buy
Stop Loss Psychology: DOC doubled, moving from $2.50 to $5.00 in a single day. This certainly grabbed the attention of a lot of traders. Some were experienced and made a lot of money and others were less experienced and bought DOC either without an exit strategy or with a strategy that would be very difficult to use.
Look at the chart above and notice what happened the day after DOC made such a huge run. The price gapped up, and many amateur traders bought in at $4.50, only to watch the price immediately plummet below $4. Surely a few of these traders took a loss and then chewed their fingernails the next day when the price climbed back up. Maybe even a few of them opened another trade as the price recovered, only to sell again as the price fell back down again the next day.
Article Continued: Stop Loss Psychology Part 2