When a trader starts his new venture into trading or investing, he finds out many things that need to be learned, understood and used as part of his tools to become successful. One of the useful tools in many trading software is the use of stop loss orders. Although this a standard tool, not many use them. Some use them in different ways to try to achieve one goal: profitability. However, some use mental stop, a method in which a trader determines a stop loss (either in dollar amount, percentage or point system) in his mind but not physically place it in the trading platform. Whereas the physical stop order is placed in the platform on the broker’s server or directly on the exchange. What is the difference between the two and what are the advantages and disadvantages of using either?
Advantages and disadvantages of using physical stops:
1. Placing physical stops remove the stress that normally accompanies the trade. Once it’s placed, there is usually a sense of relief that the risk is known and cannot be changed. This advantage is due to the removal from having to think and guess what to do next during the trade.
2. Mental stops give the trader greater flexibility that may fit his trading style where adjustments can be made according to changing market conditions. This requires thorough understanding of price action to be able to use this flexibility.
3. Mental stops are difficult to implement for those who lack discipline and concentration. Discipline is the biggest obstacle for a trader to execute his planned mental stops during the trade. Many cannot cope with the fast action of the market, handling a losing situation, or cannot even stay focused with the trading plan before the trade. This cause the wish-washy decision-making that inhibit the trader from sticking to his original mental stop. Many times, the final stop loss ends up very far off the original stop planned, thus a larger loss than planned or expected.
4. Physical stops can be a disadvantage in markets that are prone to stop-hunting, a method used by floor traders, market makers, or highly capitalized traders to move market to prices where high concentration of stop loss orders are placed. Be they in stocks, futures or commodities and forex markets, all markets are vulnerable to them, especially where liquidity is low. This is especially true in stocks during lunch hour where volume is thin or stocks that have low daily average volume.
5. Physical stops protect traders from unexpected disasters and mishaps they routinely suffer. When the stop loss order is placed, it is parked at the broker’s server or at the exchange, depending on the instrument and the exchange in which the trade is made. Having this order placed away from the trader’s computer, this will protect from outages, internet connectivity problems, trading software problems, or even the trader must attend to other priorities away from the trading desk.
6. Using mental stops can keep the trader’s focus in the trade and not be distracted with anything else. Physical stops are in place will cause the trader to be less attentive to the trade and market at hand, causing him to tend to other things besides trading. Concentration and focus may suffer. If the trader must stay focused for the subsequent trades, concentration is a must; else he may miss important information that goes between trades.
It is always recommended that the novice traders use physical stops entirely and unconditionally until he can control his emotions and discipline. In additional, he needs better understand the market before he can make rapid and objective decisions in real time in order to be flexible in using mental stops. The trader may not like the idea of being stopped out just before the market goes his way, leaving him out of the market. Each type of stops has advantages and disadvantages, but stops must be seen as insurance to keep his capital from major harm. It’s a difficult decision to make and only through trial and error and assessing personal qualities or weakness will the trader can determine which is best for him.