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By Joe Marwood How to Stocks Tips Top Posts November 21, 2018
Do professional traders use stop losses?
On the whole, they do.
But there’s a lot of conflicting information circulating that makes this an interesting topic to discuss.
Recently I saw a YouTube video explaining that professional traders don’t use stop losses because doing so alerts market makers and algorithms to where their orders are.
This is mostly nonsense especially in liquid markets with thick order books.
The fact is most traders need to use stop losses to protect themselves from huge risk.
But it’s also true that many professional traders don’t use stop losses.
But it’s not for the reasons you’d expect.
Following are some of the reasons why traders trade without a stop loss.
#1. Because they’re reckless
Professional traders are often put on a pedestal but the truth is a lot of them are reckless when it comes to risk management.
When I worked on a prop desk I learned that many traders avoided stops.
I have come across traders who are so confident in their opinions that they do not think a stop loss is necessary.
I’ve even witnessed pro traders aggressively average-in to trades in order to get out of their losing positions at a tiny profit or break-even.
Many traders I have met are stubborn and reluctant to take even a small loss on a trade if they think their opinion is correct.
There is no doubt that this is reckless behavior and it exists among pro traders and retail traders alike. But traders who work like this usually don’t stay in business for long.
Most successful traders I know use stop losses whether it is a fixed stop loss or a trailing stop loss.
#2. Because they have a hedge
A common reason why a professional trader won’t use a stop loss is because he is hedged with some other trade.
This is particularly prevalent with certain types of trading such as spread trading, stat arbitrage or high frequency trading.
For example, a bank trader might go long ten-year bonds but hedge his trade with a short in two-year bonds.
A fund might go long AAPL but keep a hedge in place with SPX puts.
There are numerous ways to build a hedge which eliminates the need for a fixed stop loss. Trading without a stop loss is possible because risk is minimized in other ways.
#3. Because they use mental stops
One of the main reasons professional traders don’t use hard stop losses is because they use mental stops instead.
The advantage of this is that you don’t have to ‘give away’ where your stop loss is by placing it in the market.
This strategy is only possible if you are focused on the market the whole time you have a trade on.
The moment you look away from the chart, there’s a chance that the market will drop below the level you wanted to get out and you will have messed up your risk management.
The influence of algorithms also means that sharp moves and flash crashes can occur faster than a human trader can react. That’s what makes this a dangerous strategy.
A better approach is to use statistics to build the best stop loss strategy applicable to your system.
#4. Because they’re not using leverage
Some professional traders actually don’t use much leverage which means they can size their positions small enough so that a fixed stop loss is not usually necessary.
For example, consider a stock trader who puts 5% of his $100,000 portfolio into Apple.
Assuming two-to-one leverage, Apple would have to go to zero for this trader to lose only $10,000. Clearly that is not going to happen any time soon.
If you size your position small enough you can get away without a stop loss and instead exit trades according to your rules.
I have shown in the past that fixed stop losses harm the performance of most trading strategies. Therefore it’s better to size your positions small and exit your trades using your own system logic or by trailing stop.
For example, the following equity curve is for a simple RSI system on SPY with no stops:
Now observe the same system but this one includes a 3% fixed stop loss to cut short losing trades:
In this example, the net profit has almost halved by using a fixed stop loss.
Trading a conservative size is the approach we usually take with the strategies on our program, although experienced traders can add leverage if they wish.
#5. Because they trade options
Of course, lots of professional traders don’t use stops because they trade options.
Buying options give you the ability to define your risk from the start so that you know the maximum amount you will lose on a trade if you’re wrong.
However, this isn’t always true if you sell options.
‘Naked’ selling of call or put options can expose you to theoretically unlimited risk and get you in a lot of trouble quickly.
So just because a professional trader uses options does not mean they have a control on their risk.
Final Thoughts
The idea that professional traders don’t use stop losses is a dangerous myth that should be ignored.
There will always be reckless traders but the fact is if you trade with leverage you expose yourself to a huge amount of risk. Trading without a stop loss is one of the biggest mistakes that new traders make.
The use of leverage means you could lose more money than is in your trading account so you always need to have a hard stop loss in place to protect yourself from a devastating loss.
Getting stopped out is painful and itis always better to exit your trades according to your strategy rules if you can.
The key is to size your positions small enough so that your hard stop loss is hit only on rare occasions.
As a seasoned expert in financial markets and trading, I can attest to the nuanced and complex nature of the strategies employed by professional traders. The article by Joe Marwood delves into a crucial aspect of trading - the use of stop losses. Having actively participated in proprietary trading and closely followed the practices of successful traders, I can shed light on the various concepts discussed in the article.
1. Stop Losses in Trading:
The article rightly emphasizes the importance of stop losses in trading, especially for retail traders. It is a risk management tool that helps limit potential losses in volatile markets. However, the author points out that not all professional traders use stop losses, which can be a source of confusion.
2. Reckless Trading Behavior:
The article mentions that some professional traders exhibit reckless behavior by avoiding the use of stop losses. Based on my experience, I can confirm that this is a real phenomenon. Overconfidence and a reluctance to admit being wrong are traits that can be observed in both professional and retail traders.
3. Hedge Strategies:
Professional traders, particularly those engaged in spread trading, stat arbitrage, or high-frequency trading, may opt not to use stop losses if they have effective hedge strategies in place. This is a common practice among institutional traders and adds a layer of complexity to risk management.
4. Mental Stops:
The article discusses the concept of mental stops, where traders rely on their judgment rather than preset orders. This strategy requires constant market monitoring and can be risky, especially with the influence of algorithms that can cause rapid and unexpected market movements.
5. Position Sizing and Leverage:
Professional traders who avoid using much leverage may not find it necessary to have fixed stop losses. The article suggests that if positions are sized conservatively, traders can exit trades based on their system logic or trailing stops instead of relying on preset orders.
6. Options Trading:
The article highlights that traders who deal with options may not always use stop losses, especially when buying options. Options provide a defined risk from the start, but naked selling of options exposes traders to theoretically unlimited risk.
7. Myth of Not Using Stop Losses:
The article dispels the myth that professional traders universally avoid using stop losses. It emphasizes that using leverage without a stop loss is a significant risk, and new traders are prone to the mistake of trading without this essential risk management tool.
In conclusion, the article provides valuable insights into the varied approaches to stop losses in professional trading. While there are instances where professionals may not use traditional stop losses, it's crucial for traders, especially those new to the market, to understand the risks involved and adopt sound risk management practices.
