Financial psychology behind Stop Loss

The correct mindset is essential for not losing money in the stock market, especially when using the stop loss. Unfortunately, people always focus on technique and never on trading psychology. 

Most trading strategies use stop-loss orders to exit the market at a certain price. 

As I have written several times, I am not a lover of day trading; I find it a waste of time. You can read this previous article of mine: Why I believe intraday scalping is a bad idea.

I prefer to invest with a medium-long time horizon rather than short-term trading. Algorithms increasingly dominate financial markets, and predicting short-term movements in a discretionary way is very difficult.

However, even when investing in the medium to long term, it is necessary to decide whether setting a stop loss is a good idea. 

In this article, I will analyze the psychological part of the stop loss and not its use on a technical level. There are many ways to calculate and place a stop loss, but our minds could play tricks on us.

Several mental biases can harm us when we use stop loss. The human mind is generally structured to avoid pain and therefore has an innate loss aversion.

the psycology of loss aversion
Image from Fqmom.com: Link

Nobody likes to admit they are wrong; instead, the stop loss collected certifies that we were wrong. Likewise, no one likes to lose money, except perhaps in the case of the pathological gambler. 

Using the stop loss could lead the investor to make some very costly mistakes unconsciously. Let’s see what they are to prevent our unconscious from making fun of us through the stop loss. 

Position size mistakes using stop loss

Many investors want to expose themselves to the market with large positions, using leverage. I strongly advise against using leverage, especially for beginners. It is one of the best ways to ruin yourself.

On the other hand, many brokers hope that you use a lot of leverage and push you to use stoploss. Those who use financial leverage must necessarily operate with the stop loss. A normal stock price movement, if amplified by leverage, can margin call a trading account.

Therefore, it is always recommended to use the stop loss, while guru traders recommend opening short positions without financial leverage. Why buy $ 30,000 from Apple with a $ 500 account? 

The investor thinks he can bypass the lack of capital by using the stop loss psychologically. He hopes to enter a trade correctly and earn big money without having the means. In most cases, when the margin call comes, it would have made more sense to play slots or blackjack.

Those who want to obtain returns with 3-figure percentages in a short time will have to use a lot of leverage and stop losses, and unfortunately, they are doomed to extinction.  

So the first mistake not to make is to use the stop loss to justify an extreme position sizing. Our mind deceives us that the stop loss allows us to go beyond the limits of our account; it is a falsehood.

The investor knows that he would never buy $ 30,000 of Apple, but his mind makes it acceptable because he is using the stop loss. 

Some might argue that setting a stoploss of $ 100 does not change anything between a large and a small position. But it’s very different; losing $ 100 for a half percentage point move isn’t like losing $ 100 if a stock drops five percentage points. In the first case, I am gambling; in the second case, I missed my entry. 

The false safety of a stop loss 

As we have seen, sometimes we use the stop loss to limit the right and a healthy fear of taking a greater risk than necessary. We are assuming that risk anyway, but our minds find it acceptable. 

Likewise, we feel comfortable setting a stop loss even if we go overnight. I have a massive position in that stock, but what could happen? I put the stop loss….

The market continuously has up and down gaps. A lot of news comes out when the markets are closed and creates a lot of volatility.

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The stop loss cannot do anything against a gap; the loss will be much higher than hoped for. We unconsciously took a risk that we consciously never would have accepted. We would probably feel unlucky in a significant loss instead of irresponsible because we had the correct stop loss.

gap risk ineffective stop loss
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Invoking lousy luck is a psychological construction to avoid accepting our mistakes. I still remember the hundreds of posts in 2015 when the Swiss bank abolished the peg. Thousands were positioned on the EurChf cross at a very high level, and it was a massacre. Almost everyone had the stop loss placed on their platform, and there were no gaps.

A lot of traders burned millions in seconds. Ruined families, money wasted only because of the leverage and the false security of a stop loss. None of those people would have agreed to invest thousands of dollars in a EurChf trade. Using the stop loss made them feel psychologically calm and burned all their money.

The same thing happened with the Japan earthquake and tsunami in 2011. It can happen again due to a supervolcano or an unexpected decision by the FED.

Investors would have suffered moderate losses without leverage and the stop-loss; many traders would not have ruined them.

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