Having a stop loss strategy to limit trading losses is a must. Every successful forex professional, has one. Here are three reasons why the failure to control losses is a gargantuan mistake (Read Part I of this 3-part series by clicking here).
- Risk is Much Greater Without the Use of Stops. This may seem obvious, but it cannot be stressed enough. Having a strategy to control losses is so essential, that it is one of the requirements in our trader recruitment program. This is why…Every time a trader opens a position, he is exposed to market risk, since the price of the position will fluctuate and so will his account equity. Consequently, the longer a trader keeps a trade open, the longer he will be exposed to market risk and the greater his total risk will be.
Undisciplined traders who hold on to losing trades waiting for a recovery have the greatest risk exposure of all. A losing position can gradually become more negative over time, getting bigger and bigger until a trader blows up in the process.
- Black Swan's Hate FX. In the world of professional trading, the term "black swan" is used to refer to an unexpected event that can drastically change the prices of currencies.
Any trader caught on the wrong side of trade during a black swan event can be destroyed; especially traders who use leverage (and most traders do).
Traders who don't use stop losses and fail to control their open negative positions properly are more susceptible to total devastation during a black swan. All it takes is for the market to hiccup in the wrong direction and the party is over. On the other hand, a seasoned FX pro who uses proper risk management and works with stops runs a much lower risk of being affected by an unforeseen, market-moving event.
- Unrealistically High Winning Percentages are Unsustainable. "Winning Percentage" measures what percent of profitable trades a trader has achieved. Any trader whose losing trades are much larger in size than his winning trades will need many winners to make up for one loser; in other words, he will need to maintain an extremely high percentage of profitable trades to stay afloat. Even though a trader might survive with a low average-win-to-average-loss ratio for a while, all it takes is a streak of consecutive large losses to force him to look for a different career.
Novice traders who do not use stop losses on their open positions at all and allow open losses to frequently sink into oblivion, are in the worst shape of all.
This can be proven mathematically (a special treat for the technically inclined!) with the equation below, which shows what a trader's winning percentage (Wpct) must be in order for the trader to be profitable, based on the his average win (AVGwin) and loss (AVGloss). The equation demonstrates that if the average loss per trade is much larger than the average gain, the percentage of winning trades must be greater than 100%, which is mathematically impossible (to see a derivation of the winning percent formula below, click here).
Consequently, the trader who doesn't use stop losses will more than likely fail over the long run. All it takes is one bloodbath and his future trading career as a pro becomes no more than a distant memory.
This is Part 2 of a 3-part series. In the next blog post, we will provide crucial advice to help traders effectively deal with the inability to take losses.
Feel free to visit our FastTrack section if you're interested in becoming a professional trader, but do not have the required experience or track record yet.
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