Thursday, September 18, 2014

The Psychology of Stop Loss Levels

Price changes in the stock market do not follow a normal distribution.  Rather, they are leptokurtic, which means that we see more small changes (higher peak) and a larger number of extreme changes (fatter tails) than we would see in a normal distribution.  Because of those fat tails, markets can move against us more than we would expect if markets followed normal distributions.  A two standard deviation event is a relative rarity in a normally distributed world, but occurs with surprising frequency in markets.

It is because of this ability of markets to move in extremes that traders rely upon stop loss measures.  A stop loss is a way of avoiding catastrophic loss.  It is also a way of trying to capture a favorable relationship between reward and risk. 

When we set stop loss points on trades, our positions reflect bets on both an idea (for example, stock prices will rise) and on a path of price movement (the rise will occur with point X being hit before point Y).  It is conceivable that our idea could be right--stocks could move higher over time--but we could be wrong on the path and stopped out for a loss.  That is understandably frustrating for traders--so much so that some traders turn to options and bet relatively small amounts of premium on their ideas so as to avoid setting stops.  Their trades will either hit their target and they'll be profitable, or they'll lose their premium.  Risk management is thus achieved partly via position sizing, rather than through stop losses and the prediction of price paths.

One reader asks the question of how we can get ourselves to honor stop levels.  He points out that it's very tempting to allow a trade to move beyond a stop, hoping it will return to breakeven.  

The problem is that the stop out is viewed as a loss--and the loss is viewed as a failure.  If the loss is viewed as the avoidance of a potentially catastrophic loss of capital and as an honorable fiduciary duty to investors (whether you're investing other people's capital or your own family's), then the stop out becomes part of good trading.  Being stopped out means that you were wrong about the anticipated price path.  It doesn't necessarily mean that your underlying idea was wrong.  The loss can be a prod to help you better manage price paths, and it can also be a prod to take a fresh look at your idea. In both cases, the loss can help make you better.

Psychologically, the trap to avoid is equating loss with failure.  Loss is a function of human fallibility; it is inevitable when trading markets.  The key question is whether you learn from losses or become threatened by them.  If you embrace losses as opportunities to learn, they won't be fun, but neither will they become the threats that lead you to avoid prudent risk management.

In general, I find that traders place stop loss points too tightly and don't anticipate the random moves likely in a given volatility regime.  The problem is not with placing stops per se, but with setting them so perfectionistically that they're almost guaranteed to be hit. Wider stops with smaller positions often allow an idea to play out--and still serve an essential risk management function.

And if you want to simply trade your ideas and not play the game of predicting price paths?  Perhaps stops are not for you and a judicious use of options could allow you to better weather choppiness and uncertainty. 

Further Reading:  Risk Management and Stops in Trading