I got the question in the title of this post from a “fan” of The Essentials of Trading Facebook page. If you’ve followed this blog for any length of time you know that the topic of stops and how to use them is a frequent concern among new and developing traders (for example Where should I put my stop and take profit orders?). Let me approach this from a couple different angles.
The market will come back
If you are not using stops because you “know” the market will eventually come back you need a history lesson. Sometimes the market never comes back, or if it does it’s after such long period of time or such a big drawdown that you can’t hold on for the duration. Take a look at this S&P 500 weekly chart.
Imagine if you had bought the market back in the fall of 2007 when the S&P was trading at 1500+. If you had not had some kind of protective downside exit plan you would have seen a loss of more than 50% on that position (not accounting for any leverage, which if employed would have wiped you out). That’s a hard thing to sit through, as many people who attempted to do it can tell you. The market has come back up quite a bit but is still more than 400 points below where it was. How long is it going to take to get back to those 2007 levels? Who knows. It could be years – years to get back to break even, meaning no gains for all that time in the market and your money tied up preventing you from trading anything else.
If you’re thinking “well that’s too long a time frame, I trade shorter-term” then look at charts in your time frame. I guarantee you’ll find examples of formerly choppy markets that would always come back becoming very unidirectional. You play that game long enough you are going to get burned badly.
Want an example? How about what GBP/USD did in a week.
The market rallied 700 pips between October 13 and 20. That’s a big hit if you were short. If you were trading with a modest 10:1 leverage ratio you might have survived the hit (at least so far), but it wouldn’t take a much higher leverage ratio to have seen a margin call triggered. Poof! Account wiped out. 🙁
My trading systems doesn’t use stops
This is a legitimate reason not to use stops, and is the reason why you cannot accept the blanket statement that all traders must use stops. If you do as much system testing as I have done over the years you will observe that there are types of systems which do not show improved performance when stops are introduced, expect perhaps in the most loose of fashion. These tend to be trend trading oriented systems, particularly those which are always in and/or use close and reverse type approaches.
Be warned, however. Some systems do leave you exposed to potentially large losses because of the timing of when positions are exited and/or reversed. You should be aware of these potential holes and make sure you have some kind of protection plan to guard against extreme moves. That might mean a very loose stop loss order or perhaps an out of the money option.