How to use stop losses effectively [4]



When are stop losses most effective?

While I advocate using stops on every trade involving a margined product such as cfds and spread bets, it remains true that the effectiveness of stop losses as an overall money management or capital preservation strategy is heavily dependent on the prevailing market environment.

So which type of trading environment is best suited to stop loss trading?

Choppy, range-bound markets—in trading ranges, where prices are not trending, you will see trades get stopped out only for the share to then move in the direction you originally anticipated. In this sort of trading environment, stoplosses would appear to be ineffective and perhaps costly.

Momentum-driven markets—on the other hand, stoplosses tend to come into their own in momentum-driven, strongly trending markets. This is because in this sort of trading environment, trades only tend to get stopped out when a short term trend comes to an end such that the spread trader would have been much worse-off without the stop.

Stop loss strategies

Static stop losses—traders that use a static stop loss approach simply set the stop level and never readjust it as the market moves. The stop loss is not used as part of an exit strategy and its sole purpose is to protect the downside in case of a loss.

Trailing stop losses—as the name suggests, trailing stoplosses move in line with the underlying market price. For example, say you have a buy bet on a share and your position is in profit, to protect the some of the gains that you have made, you can simply move the stop loss level higher as the underlying share price rises. This way, you get to track the gains higher until you eventually get stopped out of the position.

Notice that in the trailing stop loss approach, the stop is an essential part of the trade exit strategy since the spread trader simply moves the stop higher until stopped out. This strategy is particularly effective in strong trending market as it enables the spread better to stay in the trend for as long as possible.

Stop losses: summary

Stop losses are not provided free of charge by the spread betting companies. However, what little cost you incur by using them may pale in comparison to the potential losses that their use would undoubtedly prevent sooner or later. Consequently, I advocate the use of guaranteed stop losses by all beginners to financial spread betting.

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