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Fallacy Of Adjusting Stop Loss To Breakeven

02/21/19 04:11:48 PM
by Fawad Razaqzada

Tightening the stop loss is a key risk management concept, but moving it to breakeven for no technical reason invites subjectivity in your decision-making, potentially preventing yourself from making a profit.

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Some inexperienced or developing traders don't see small losses as necessity and will do anything to avoid them. One of the bizarre things they often do is this: adjust the stop loss from its original location to breakeven as soon as the trade goes into profit and without any technical reason, thinking they cannot now lose as the worst outcome is a breakeven scratch. In fact, reducing risk quickly and moving stop loss to breakeven is something that many trading coaches advise people to do, but without explaining how and thinking about the consequences.

Let's think about this for a moment. Imagine you are buying Apple (AAPL) shares at $150.00, which you think is a key support level for whatever reason, with a stop loss just below your invalidation level at $149.00 and a target at $152.00. AAPL starts trading down and before long hits $149.95 and therefore triggers your buy order at $150.00, which means you are now long. Price then moves quickly to $150.70 and you think "great!" and decide to move your stop loss (SL) to breakeven (BE), not because of any technical reasons but just so you don't lose any money on this trade. But it then comes back to trade at $149.93 before shooting up to your intended target of $152.00, only it got there without you as your adjusted stop loss was triggered. What you have done here is offered to sell your Apple shares around the pivotal $150.00 support level. Think about that — you have sold at support. Shouldn't you be buying at support and selling at resistance, instead? Of course it is important to reduce risk and adjust your stop loss as the trade goes in your favor, but you only do this if it makes actual sense from a technical point of view. If Apple creates a higher low at $150.20, for example, before pushing above the day's earlier high of $150.70, then tightening the stop loss to BE or slightly higher would make sense, for if price were to break the higher low at $150.20, it may mean the trade idea is no longer valid as the selling pressure is mounting. But you don't move the stop just for the sake of avoiding a loss and without any technical reason.

To illustrate exactly what I mean so you avoid making the same mistake, consider the example below, showing the daily chart of the E-mini S&P 500 futures.

Figure 1. Daily chart for E-mini S&P 500.
Graphic provided by: eSignal.
 
In this example, the S&P 500 futures created a large bullish engulfing candle that moved us above the closing price of the previous day, thus signalling a reversal in the trend. Let's say that the trader decides to buy at the open on the next day at 2471, where the index had closed when it formed that engulfing candle. In this case, the original stop loss was, say, below that daily bullish engulfing candle at 2316, with a target at 2729, which would have provided just under a 1:2 risk-reward ratio. Over the next three days or so, the market moves higher and the trader rightly decides to reduce the risk. The correct position to move the stop to would have been below the candle that was formed on the day after when the big reversal took place, at 2397. However, the trader decides to move the SL to BE, just so he/she doesn't lose anything on the trade in case it reverses again. Lo and behold, the market comes back down and triggers the now-adjusted sell stop loss order. It then bounces hard and moves towards the intended target, eventually reaching it a month later. So, the mistake of the trader here was that he/she sold right at support despite the bias being bullish on the daily time frame. But he/she didn't think about this when adjusting the stop loss.

Of course, the above example is based on the daily time frame and requires a wide stop at the outset, and many people would not be comfortable with that wide of a stop, but it is just a hypothetical situation. However, even if this took place on a smaller time frame, such as the 60-minute, the idea would have been the same. Tightening the stop loss is a key risk management concept but moving it to breakeven for no technical reason can become very frustrating as usually the location where you buy is in theory a support level or support area. So why sell it there? In the above example, the stop loss could have been adjusted even above entry, but only once the market made a higher high. It could have been trailed below each subsequent higher low as the market moved higher. The thinking here is that if, and when, the market makes a lower low again, then at that point the trade would no longer make sense and should be closed. That is an objective way of knowing that the uptrend has ended. But by adjusting it for no technical reason, you are inviting subjectivity in your decision-making and preventing yourself from making a potentially decent profit.



Fawad Razaqzada

Fawad Razaqzada is an economist and market analyst who has been involved in the financial markets for almost 10 years. He has worked for several leading brokerages as a market analyst, in London. Specializing in FX, commodities and stock indices, Fawad is regarded as an expert at reading price action on the charts. Together with his deep understanding of economics and fundamental analysis, he can forecast short term price fluctuations with enviably high degree of success. Fawad has also been trading on his personal account for many years. Follow Fawad on twitter @Trader_F_R

Website: twitter.com/Trader_F_R
E-mail address: fawad.razaqzada@hotmail.co.uk

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