Stop Losses: Insurance You Don't Always Need

Stop losses are often presented as an essential part of trading, almost as dogma. "Never trade without a stop loss," we hear from all sides. But is it really that straightforward? Let's take a more critical look at stop losses and explore alternative approaches to risk management.

Stop Loss: Insurance with a High Price

A stop loss functions as insurance – it limits the size of potential losses by automatically closing a position when the price reaches a predetermined level. But like any insurance, it comes with a cost that can be surprisingly high:

Realizing Losses That Could Turn Into Profits

One of the biggest problems with stop losses is that they often realize losses in situations where a more patient approach would lead to profit. Markets are volatile, and natural price fluctuations often hit stop loss levels, only to return to their original direction afterwards.

Example: Imagine you bought Bitcoin expecting it to rise. You set a stop loss 5% below your entry price. Overnight, a short-term fluctuation triggers your stop loss, and you wake up to a loss. A week later, Bitcoin is 20% higher – but you're no longer in the market.

Stop Losses in Momentum Strategies vs. Other Approaches

Stop losses may make sense primarily in certain types of strategies:

• Momentum strategies: They can be useful here because the basic premise is that the price will move in a certain direction. If it starts moving in the opposite direction, it may signal that your thesis was wrong.
• Mean reversion strategies: Here stop losses can be counterproductive because the strategy is based on the assumption that extreme movements will return to the average. Premature position closure may thwart the very moment the strategy is waiting for.

Alternative Approaches to Risk Management

There are many more sophisticated ways to manage risk without needing to use traditional stop losses:

Dynamic Position Sizing Based on Forecast

In advanced trend following strategies, position size can be dynamically adjusted according to signal strength and forecast of future movement:

1. Smaller positions with weaker signals - When the forecast is less certain, position size is automatically smaller
2. Gradual increases/decreases - Instead of suddenly closing the entire position, you can gradually adjust its size according to the situation – for example, reduce it when realized volatility increases

This approach means that no single position has the potential to wipe out your account, because the size of the risk is set in advance to a manageable level.

Diversification as Natural Protection

Instead of relying on stop losses for individual positions, it is often more effective to focus on:

• Diversification across instruments - Trading multiple different assets that are not strongly correlated
• Diversification across time frames - Combination of short-term, medium-term, and long-term positions
• Diversification of strategies - Implementation of different trading logics (trend following, mean reversion, carry, value...)

With sufficient diversification, the probability of simultaneous failure of all positions is significantly lower than with a concentrated portfolio with stop losses.

Time-based Exits vs. Price-based Exits

Instead of closing a position based on price, you might consider:

• Time exits - Closing a position after a certain time if it doesn't reach the desired profitability
• Volatility-based exits - Adjusting the exit point to the current market volatility
• Change in fundamental conditions - Exiting based on changes in fundamental factors, not just price

Why Stop Losses Are Not a Universal Solution

Statistical Consequences

From a statistical perspective, stop losses:

• Cut off the negative tail of the return distribution, which sounds good
• BUT also change the overall shape of the distribution, often reducing expected returns

Psychological Trap

Stop losses often serve as a psychological crutch that can prevent the development of true discipline:

• They create a false sense of security
• Can lead to greater risk-taking because "we have a stop loss after all"
• Encourage short-term thinking instead of a strategic approach

Conclusion: Consider Your Strategy

A stop loss is neither a good nor a bad tool – it's just one of many risk management tools that has its place in certain strategies and situations.

Before automatically setting a stop loss for every trade, consider:

• What type of strategy are you trading?
• How diversified is your portfolio?
• What is your time horizon?
• How much capital do you allocate to individual positions?

You may find that in some cases stop losses are useful, while in others there are more effective ways to manage your portfolio risk.