Cope with loss aversion and use stop losses effectively

Adrian Holliday 16:44, 6 March 2018

Knowing when to quit is a life skill. With trading and investing a clean exit is generally a combination of judgement and luck.

But there are tools to help, such as stop loss orders. If you put time into understanding how to use stop loss entries smartly, these can dramatically improve your trading performance. And you get more time for the market to return, possibly favourably, in your direction.

But stop loss orders can be misused, particularly by traders suffering from loss aversion bias. Here are few common mistakes:

If you have recognised yourself in any of these scenarios, be warned, you are possibly being influenced by loss aversion bias. All of us carry stuff like this in our heads that mess things up.

Knowing your loss aversion risk will make you a better trader – especially when using stops: Shutterstock

Loss aversion in trading is when we struggle to give up a bad position. We tell ourselves: It needs time…It will come back…I really respected the person who gave me that advice… And, worst of all…I just want my money back (sometimes tagged ‘refund-itis’). Trading and consumer rights legislation are terrible partners. 

And on it goes. Meanwhile no energy is given to new opportunities, to trades that will be profitable. So how to de you tackle this loss aversion bias by correctly using stop loss orders?

Market mastery – losses are normal

First, a reminder. Losing is part of the plan (and all good traders have a plan). Also, a good trader needs volatility and they need risk. Without both, trading would not exist. Every trader loses some of the time.

Master this psychological trap and you will cope with most trading situations. If you can’t handle the idea of regular losing, sometimes exacerbated by leverage, have a quiet word with yourself.

With that caution out of the way, let’s look at ways to keep ordinary losses under tight control while being aware of those in-built loss aversion tics that may lead us astray. For many traders these biases threaten passivity and inaction. They must be fought. 

Stop loss orders – what they do and how to use them

The point of a stop loss order is to help you worry less about volatility. If the price of a stock dips below a certain price you’ve set, an order to sell (or, going the other way, buy) is made. Automatically. 

Your key is that you do not have to think about managing this process while the trade is live, while you are emotionally attached to it. This risk management process goes to the heart of managing losses effectively, countering any loss aversion sentiment hanging around.

A stop less order can get you out of trouble if you’re emotionally invested with that trade – and without you having to even think about it.

A stop order to sell at a set price is by no means guaranteed. Markets can spike. They move fast. A stop order may not be able to be executed if the order is piled behind other stop orders further ‘up the line’ than yours. Or, an order is too big and needs to be done manually. 

Remember that some stocks – especially where the bid-ask spread is wide – are also naturally more volatile.

Stop loss orders help you control volatility and losses – and they are ruthlessly effective at stripping emotion out of a trade

Know the break-even maths

How you manage stop losses depends on how aggressive or cautious your trading style is. If you’re too conservative you may fail to take advantage of true price volatility. Or you may make a stop loss order wider than it needs to be. But you need to be aware of all costs.

Moving your stop loss once a trade has moved in your favour can be a wise move, providing you do not rush to move it too soon or too far.

Let’s say you have a volatile asset that regularly fluctuates 5% in either direction. You need to set your stop loss outside that the range of a normal price swing – at least 6% and possibly wider. How wide depends on your personal attitude to risk.

If the price moves up in two or three waves, with the average price now 4% above your entry point, the standard 5% swing still brings the possible low point in a cycle below your entry point. The sensible thing to do is either not to move your stop loss yet, or move it just a few percentage points, keeping it more than 5% away from the average price.

The trouble here is if fear kicks in. You can see a profit on paper and, thinking you can tie that profit in and avoid the risk of losing money, you move your stop loss too early or too close to the new average price.

If you move your stop loss to your entry point, a normal 5% swing will trigger your stop loss and close your trade. You won’t have lost money – you will have broken even – but you will have missed out on a profitable trade.

There are tools to help. While an ordinary stop loss can be used, a tracking stop loss can follow behind any price rise. It will only be triggered by the margin you pre-set. This can be a good way to lock into profits. It helps tackle in-built worries of losing any gains – the flip side of loss aversion. 

Know your range - deploy the ATR% stop-loss 

What is the sweet spot for your stop-loss order? A too-wide stop could see more potential for bigger losses, while a too-narrow range shuts down the potential for profit. This is where using an Average True Range (ATR) figure can help.

An ATR figure – it’s normally supplied in an indicators chart from your broker – supplies a number for any set period of time. The ATR tells you about how much an asset might fluctuate – and the underlying strength of these fluctuations within a set trading range – ­rather than the direction it’s headed. It’s often measured on a 14-day default time frame.

Generally, the higher the ATR number, the more volatile the trading environment (and the higher risk).

The true range figure is taken from three different calculations. Generally, this is the highest distance between today’s absolute high and low; today’s high and yesterday’s close price; and yesterday’s close and today’s low

The ATR gives a feel for the historical volatility of a security. That helps to set your stop level. You decide what percentage gap you want your stop loss to cut in and apply that to the ATR to give you the correct sized gap.

Stop losses offer real potential for profits – but they must be used carefully and methodically: Shutterstock

Remember, you need to apply the appropriate percentage – most traders suggest the maximum should be 2%. A £100 stock that goes up or down £10 a day will need a different ATR to a stock that typically trades £1 up or down within a daily trading range.

Applying the same logic, some currency pairs are more volatile than others.

Let’s say you’re trading the euro and the latest ATR value is 120 points. You set your stops a fixed distance from your entry point, depending on your strategy. So two ATRs would be 120 x 2 = 240. This is the number of points – 240 – away from the entry price or support line at which you set your stop.

If you had a target profit range of 375 points then your profit ratio is worked out as 375 divided by 240 = 1.56% loss limit (well within a 2% loss limit though not including fees).

The ATR value is especially useful when you’re comparing volatility across a range of different instruments, or comparing volatility within the same asset class – euro-dollar compared to yen-dollar.

The ATR applies to the full gamut of trading stop and loss options – forex, stocks, etc. It will target and evaluate any trading range, be it a narrow intraday time frame or several weeks, even. The kind of trader you are dictates your percentage, with day traders generally at the smaller end.

The overarching use of the ATR is to give you a shot of empirical, chart-based logic to help you place your stop-loss at the right level for the market. In other words, the ATR number gives you perspective by smoothing out all jumps and falls. It never, bear in mind, gives you market trend direction.

So, an ATR figure helps set your stops. This is useful first thing in the day when you’re deciding on where to place them: positioning them a set amount from your entry point. You want to create the opportunity for your trade to move in your direction without getting stopped out from market disruption – noise, sudden news events, general whipsawing, etc.

But – key here – you must create a stop that overrides any emotional attachment you have to a trade. An ATR figure is also useful for comparing volatility levels across a range of financial instruments – or different types of instrument within the same sector (pharma vs utilities; FTSE 100 vs FTSE 350).

Whatever stops loss order you use or however your choose to set them, the key it so set stop losses without letting biases impede judgement.