Physical vs. Mental Stops… The Debate Continues

| July 14, 2010 | 0 Comments

Do you remember where you were on May 6th of 2010?

No?  Well, this was the day the Dow fell 1,000 points in a matter of minutes.  Now do you remember?

A lot of other traders sure remember that day.  It was the day many of them were handed huge losses.

Yes, the “flash crash” caused headaches for traders everywhere.  The huge intraday plunge left many with big losses.  Stop loss orders were triggered left and right as the market plummeted.

Their stops were set at appropriate places to control risk.  But the insanity during the crash took out those stops at unfair prices.  Some of these trades were cancelled afterwards, but some were not.

Of course, the market rallied after the plunge…

It left those with physical stops in the market scratching their head… and wondering where their money went.

I’ve actually heard some traders say they’ve sworn off physical stops due to the flash crash.

This brings up the old argument of which is better to use… a physical or mental stop?

This argument has been going on for years.  Some say physical stops are the best.  Others say mental stops are the only way to go.

So which is it?  Which one controls risk the best?  Let’s take a look…

As you may know, entering your stop order into the market places a physical stop.  Once placed, the order is usually held on your broker’s server.  Sometimes it may be held on the exchange servers.

Either way, the order is held until it automatically triggers, expires, or you cancel it.

With an event like the “flash crash”, a wide stop loss can get triggered.  And sometimes a fast moving market can “carry” a stop loss order before filling it.  After all, a stop loss order turns into a market order once it is triggered.

This is the major downside of physical stops.  Sometimes, your order can be filled at unfair prices.

A mental stop is one you keep to yourself…

You have a set point where you’ll control losses… just like a physical stop.  But you don’t enter the order into the market.  You can leave it written on a notepad sitting nicely on your desk… or maybe in a spreadsheet.

By using a mental stop, you avoided getting stopped out at ridiculous prices during a “flash crash”.  Your order isn’t in the market so it can’t get filled.

So there’s the benefit to mental stops… you don’t have to worry about getting taken out at unfair prices.

But not so fast…

There’s an aspect to mental stops you should consider.

You must have excellent discipline to use them.  When your mental stop gets triggered, you actually have to follow through and sell.

But you may think, “I really don’t want to take a loss right here.  I’m going to hold it for a while longer… it’s going to come back.”

More often than not, the stock keeps going down… and you keep holding.  All along thinking the stock is going to rally and erase your loss.

Eventually the loss gets so large you’re forced to exit the trade.  You end up taking a much larger loss than you originally planned.

Do this repeatedly and you’ll find yourself with a much smaller trading account…

So what do you do?  Should you use a physical stop or a mental stop?  What’s the best way to control risk?

Well here’s how I do it…

I use mental stops all the time.  I know how much I’m willing to risk on each trade.  I know exactly where I will exit if the trade goes against me.  If the stock reaches my mental stop loss, I exit with no questions asked.  I move on to another opportunity.  It’s that simple…

If you have the discipline to exit a trade like this, then you can use mental stops.

But if you’re like a lot of investors… you can’t do it.  You can’t cut your losses when you need to.  You let your emotions get in the way.

If you’re like this, you should use physical stops.  You haven’t developed the discipline you need to use mental stops.

The bottom line is this…

Both types of stops have their ups and downs.

In most situations, physical stops are just fine.  They get you out of a trade when you want.  But in some cases, like the flash crash, they can turn into a nightmare.  A fast moving market can carry your order and fill it at bad prices.

Mental stop losses are better if you have the discipline to use them correctly.  You get out by following your rules and selling when you need to.

It all comes down to you and how much discipline you have…

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Category: Technical Analysis

About the Author ()

Justin Bennett is the editor of Commodity ETF Alert, an investment advisory focused on profiting from the ebb and flow of important commodities via ETFs. The commodity veteran and options specialist is also a regular contributor to the Dynamic Wealth Report. Every week, Justin shares his thoughts with our readers on a variety of commodity-related topics. Justin is also a frequent contributor to Commodity Trading Research’s free daily e-letter. And he’s the editor of another highly successful and popular investment advisory, the Options Profit Pipeline.

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