Futures traders use two types of stop losses when they trade: mental stops and physical stops. It’s important to understand the difference between the two and figure out how and when to use them. The purpose of a stop loss is to limit your trade losses. When traders set a stop loss, they are determining the specific price at which they will sell to limit their loss — in other words, their exit strategy.
Mental stop loss. When you set a mental stop loss, you tell yourself, when the market reaches this price, I will sell. Mental stop losses must be decided before you enter the actual position. To minimize your loss, you determine your exit strategy before you start to trade. Now comes the hard part. When the market reaches your predetermined price, you must have the personal discipline to obey your mental stop loss and quickly cut your losses.
The benefit of using a mental stop loss over a physical one is that only you know that you are using a stop loss and what your stop price is. What other market players don’t know can’t hurt you. You don’t want to be forced out of position before you’re ready. But mental stop losses require extreme self discipline. You also have to watch the market continually so you know when to execute your stop loss. If you can’t force yourself to get out at your predetermined price, or if you are unable to track prices on your positions throughout the day, mental stop losses are useless to you.
Physical stop loss. A physical stop loss is a stop limit order you place with your broker. If the market reaches a specific price, your broker will sell automatically. There are two kinds of physical stop loss orders: stop limit and stop market.
- Stop limit. Once the market reaches your stop loss price, a stop limit order will be placed to sell at your specified price or better. The advantage is you’ll get a better price. The disadvantage is that your order is based on a specific price. If the market declines quickly, it may plummet below your stop limit and your sell order may never be executed.
- Stop market. A stop market order is preferred for its greater reliability. In a stop market order, when your stop loss price is reached, your sell order becomes a market order and must be executed at the next price. You may lose a fraction more than you planned on, but it’s less risky than the loss you could be saddled with if your stop limit order is never filled.
Determining where to set your stop loss depends on the individual trader’s risk tolerance. You must decide for yourself the amount of risk you can afford and that you’re comfortable taking. Successful futures traders must learn when to cut their losses and move on to the next opportunity.
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