Why a stop loss order doesn’t always stop losses
But watch out! There is no warning label that explains when you are about to place a stop loss order.
A safe sounding order that could be dangerous?
One of the safest-sounding order types is the “stop loss order”. It sounds perfectly clear. This order would be placed in the market to prevent you losing more than a specific amount on a given position.
A stop loss order is used to exit trades when a specified price is hit. However, many traders use stop loss orders without really understanding the risk involved. They know what the order type is called, but they really don’t understand exactly what it is and how it works.
Using market tools that you don’t fully understand exposes your trading account to real risks that you might not understand as well. In the futures market, the burden is on you to know exactly what you are ordering before you do it.
How does a stop loss order work?
When traders enter a stop loss order in the market, they set a price at which the order becomes active. As soon as the asset covered by the order trades at the price of the stop loss order, the order becomes a market order and will be filled immediately.
It sounds pretty straightforward, doesn’t it? It also sounds like a very safe way to limit trading risk. But there is just a bit more to this order type. And, the little bit more can actually turn into a very dangerous risk for unwary traders.
If the asset doesn’t actually trade at the specified price of a stop loss order, it is never activated. The market could continue to move against you and your losses would just continue to mount.
Just imagine if you were holding a long position in the GLD when it was trading at the $114.00 level. You decide to protect your profits with a stop loss order at $109.00. As the asset price begins to fall, you might feel safe. But, if you aren’t watching closely, the fact that the GLD never actually traded at $109.00 might have been overlooked. If so, you would have been left holding it as it dropped all the way to $101.00. It doesn’t take a big gap in the asset price to cause serious damage to a trading account. It just takes a gap big enough to skip over the price of your order and then a trend that continues to move against you.
If the market gaps over the trigger price of a stop loss order, it never becomes active. Then an inattentive trader is left holding the bag for greater losses than they realized were even possible.
Traders who are not aware of this characteristic of a stop loss order might not even be aware that they are still holding the open position until they happen to check.
Why even use a stop loss order?
There is no one type of order that covers all circumstances or situations. There are times when the market just panics over what turns out to be insignificant problems.
Take Apple computer last August, when a false rumor stated that the company might have violated SEC regulations with a news release. The stock gapped lower at the open when a stop loss market order would have exited an open position for a huge loss right after the market open.
Because the stock gapped down so violently, a stop loss order would not have been triggered and the person holding the position could have taken time to find the real facts. In all likelihood, they would have cancelled their stop loss order and allowed the position to recover.
This feature of the stop loss order protects you from being taken out of a trade during a flash crash. Flash crashes are situations where the market suddenly gaps down. Then, just as suddenly, it will recover by gapping back higher. As we see more and more of these very fast dives and recoveries, the stop loss order becomes a more attractive order type.
A stop loss market order would have been executed at a large and needless loss right at the open. By the end of the day, the price had mostly recovered.
Know your orders and improve your trading success
It is important, but not difficult, to know exactly what type of order you need to place to provide the account protection you are seeking. Stop loss orders are a useful tool for specific situations.
The futures market does not allow you to return your orders for a refund if you don’t like the results of your orders. Therefore, it is crucial to get them right before you place them. You have to look beyond just the name of an order type and understand precisely how it works before using it.
Once you start entering the orders that produce what you want, the results will always be what you expect. No one order type is best for all situations. Using stop loss orders correctly will help you protect your trades and stop your losses.