Using Stop Losses

In this video tutorial, I want to talk about why I hate to stop loss orders. To begin, today, we’re going to completely close the case as to why using stop loss orders creates more losing trades with risk defined strategies.

I know it’s probably hard to believe now because you’ve been probably taught in so many different schools and classes and courses online that you’ve got to use stop loss orders because they protect you.

But frankly, they create more losing orders, and I’m going to show you why they do it because it's not something you can argue with. It's based 100% on math and probabilities, and you just can’t argue with these numbers.

Remember, this is strictly for risk defined trades, so these would be credit spreads, iron condors, butterflies, debit spreads, etcetera.

If you've got undefined risk trades, those are going to be a little bit different, and I think that at some point, you could use a stop loss because you got to just cut the bleeding. You don’t want to have an unlimited risk in perpetuity.

Here’s why stop loss orders don't work. It all comes down to the fact that in the markets, we can calculate exactly the probability of an option expiring out of the money. In Thinkorswim, our broker that we use, we use what’s called “probability ITM.”

You can see for this SPY trade that we had; we sold a credit call spread above the market, we sold the 208 options which are the line highlighted and then bought the 209 options above that. It’s risk defined.

We know exactly how much we can make or lose. In this case, SPY is currently trading at 201.63. The probability from the time that we entered this trade until expiration which is about 34 days, it's February expiration, the probability of us losing on this trade or SPY being in the money, meaning closing beyond our 208 strikes is just 23.39%.

That means that we’re trading with better than 75% chance of success on this trade because the likelihood of SPY going all the way up to and above and staying above (more importantly) 28 between now and expiration is 23.39%.

That’s a high probability trade. That means that three out of four times, you’re going to win on this trade. That’s a high probability trade if you let it go all the way to expiration.

Here’s why stop loss orders create more losing trades. Because if you have a stop loss order in here and you start to lose on this trade, the stop loss order is going to trigger it and it’s going to get you out of this trade, specifically what we find when we calculate the probability of a touch.

Probability of touch means SPY at sometime between now and expiration goes up to and just trades at one-time just one contract or one share traded at 208, the probability of that happening is 48%, so it’s almost double the probability of SPY staying up there.

If we put it another way, it would be saying it like this. SPY has a 75% chance of closing below 208, but a 50% chance of at some point trading at 208. That means that three out of four trades are going to be winners if you let them go all the way to expiration.

But during that process, two out of four trades are going to be 100% losing trades at some point between now and expiration and half of them are going to come back in.

It’s a powerful stat that you just can’t argue with. The probability of touch is almost always double your probability of losing on the trade. That means that more than 50% of the time, you’re going to be holding a losing trade that won’t end up being a loser.

If you use a stop loss order, you’re going to be closing a trade that may come back in and become a winning trade. That's why I think that stop loss orders create more losing trades.

The best thing that you can do is trade small and trade high probability strategies because you can let them go all the way to expiration.

Using a stop loss order would get you out of this trade with a loss 50% of the time compared to just leaving the trade on and doing nothing, the lazy trader mentality that we talk about. Leaving the trade on and doing nothing, you'd have a higher chance of success.

Here's just one example of many, much, much more from my trading account that we recently just experienced. We had also sold a credit call spread above the market in XLE, and you can see here we put the date of the trade.

We sold this strategy on 12/10, and it was a 78/80 call spread above the market. Ideally, this trade would be losing money if XLE traded anywhere above 80. We’d be losing a lot on this position if it stayed up there.

We traded this spread and sold it for $62 per spread, and we did four of those, and you can see that right now with two days to go until expiration, the spread is currently trading for just $2, and we’ve got about a $240 profit.

But it wasn't always this way. Here's a chart of where XLE was trading during the duration of this trade. You can go back and look at this because all of this stuff is pulled right from our broker.

We don’t mess with any of these charts and move things around like other guys that we've seen out there do. We know that this is all factual evidence about trade times and trade prices.

The red circle in this chart, this is the actual day that we made this trade, this is on December 10th, we sold that call spread above the market, and the blue line on this chart represents where our short strike is at 78.

You can see that as soon as we made this trade, we had a little bit of good movement in the stock. The stock went down, that’s what we wanted to see. But just three days after we made the trade, the stock went on a rally and started to trade above our short strike.

For this week and a half to two week period, the stock was trading completely in the money. This is that probability of touch that we were just referencing on SPY.

The stock was trading all the way above 78. It was trading at about 80 for a week and a half. At that point, we were holding a full loser.

We had a full loser on our hands, we weren’t going to make a dime on this trade, but we didn't close out the trade, we didn't use a stop loss, and you can see it did, in fact, come back in and ended up being a big, big, big winner for us in our portfolio.

This just really proves the point that with these risk defined trades, you've got to let them go all the way through until they show a profit. If they don't show a profit right away, know that almost half of the time, those that are showing a loss will show a profit, and that’s just the way that the numbers work out.

You can’t use stop losses because had we use the stop loss, in this case, it would’ve created a major loser. Again, using stop losses or trying to adjust, we might have ended up with a losing trade on this position versus just waiting and let the numbers work out in our favor.

This closes the case. With stop loss orders, they create more losing trades because it gets you out early when you have a higher probability of success waiting longer in the position.

As always, if you have any questions or comments, please add them right below this video in this lesson page. Until next time, happy trading!