Airbags in car help to protect the driver in the event of car crashes. However, airbags cannot guarantee the survival of the driver and passengers in all scenarios.
Stop loss order is one of the favourite risk management strategies used by traders. If the price falls below the sell stop order, the trader’s position will be closed and hence, the loss is limited. This will help the trader keep to the risk reward ratio of his strategy.
While stop loss orders work well in most situations, they can fail when the market becomes volatile and especially when there are price gaps. Stop loss orders are most vulnerable to price gaps.
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I experienced the vulnerability of stop loss order in a trade done two months ago. I took a long trade on Cree Inc (CREE) and placed a stop loss at $72.97 but the price gapped down and my trade was closed at $61.53. This gap cost me additional 16% loss. This is an example where the risk reward ratio was violated and screw up the returns of the strategy. I have more examples of stop loss failures in this post.
Importance of sticking to planned risk-reward-ratio
The edge of a strategy is defined through a combination of risk-reward ratio and win rate percentage. For example, if your planned risk-reward ratio is 1:2 and you have a win rate of 35%, your strategy is profitable. However, due to price gaps which result in you losing much more than planned, the strategy becomes unprofitable. Hence, you will need to refine the strategy to increase the win rate or aim for higher risk-reward ratio, to create the buffer for price gaps. Gaps can happen more often than we think.
Risk management cannot protect against Black Swans
Traders can still blow up their trading accounts even if they follow their risk management strategies. The failure of Long Term Capital Management is a good example. Diversification was not working when everything suddenly became correlated. This is the harsh reality every trader must accept. No matter how robust your risk management is, you stand a chance to blow up one day.
To reduce, and not totally eliminate, the chance of blowing up, traders should put in more layers of risk management checks. In the National Geographic documentary series, “Seconds from disasters”, the common trait of these disasters was that accidents happen due to an alignment of factors, but never contributed by a single factor. Traders should adopt the Swiss Cheese model, to put in ‘gates’ to prevent the alignment of the holes when slices of cheese are put together.
To decrease the risk in road accident, you can drive a car with airbag, driving the car within speed limit, and maintaining a safe distance from the car in front. Without a doubt, each of this risk management rule will help you improve your safety, but never protect you against other reckless drivers knocking into you. Similarly, risk management rules like diversification, position sizing and stop loss orders help to protect the trader one way or another. More layers of such risk management rules will help to improve trading safety, but never able to remove risks in totality.