Soft vs Hard Stop Losses

I haven't done a public post since October 2020 due to focusing on trading, watch-lists maintenance and subscriber updates. Moving forward I am hoping to write a series of public blog posts that focus on areas that traders/investors feel might be directly useful in improving their own skills. I have had a number of direct trading questions from subscribers over the past several months and I think sharing this dialogue would be useful to others. Today, I want to focus on the notion of using soft vs hard stop losses and the pros and cons of each.

Question:

I wanted to get your thoughts around using soft stop losses versus hard stop losses as I notice on some of your portfolio updates it looks like you are using soft stops and will ride a momentary dip out. To date I have been using hard stop losses for both quick trades and within the stock/etf portfolios. For the portfolios it seems to work pretty well as there is more breathing room and typically less volatility. On the quick trades, I seem to get stopped out more often on a momentary dip or market volatility. I understand these dips can also lead to a further decrease below the stop loss so it is great protection in that case. I do however check the quick trades on a daily basis and have notifications through my trading platform that let me know if there is any significant increase or decrease +/-5%.

One concern that I have around using soft stops is if the trade blows past or opens below my stop limit thus increasing increasing my loss. A second concern is my diligence to stick to the script on a mental stop loss so that I don't ride a momentary dip that turns into a larger downtrend (buy&hold mentality).

It would be interesting to get your viewpoint and thoughts.

Answer:

Regarding the stop losses, I have become a "soft stop" guy. I used to set hard stops in order to stay disciplined (especially with the initial stop loss after purchasing) but like your experience, I was getting stopped out only to see the price reverse higher and take off without me. The reason this tends to happen is that other traders have the same stop loss in mind (a swing low for example) and once that stop gets hit, everyone sells at once and the selling quickly dries up, which creates the conditions for a reversal (i.e only buyers left). What I do now with the quick trades is when a stock falls below the stop loss, I watch it until just before the market closes. If it has not reversed back above the stop loss by the end of the day then I will sell it.

Of course there are trade-offs with that method because sometimes a stock will just keep dropping. If something drops and it isn't consistent with my interpretation of the historical price action, then I just sell it immediately. Sometimes it will reverse higher after I sell it but that is a part of trading that we have to accept. Certain things are simply unknowable, so it really becomes just a matter of doing our best to minimize the damage and move on to the next trade.

One challenge with soft stops is that they are harder to manage when you have other time commitments. Sometimes things happen quickly and if you can't look at your screen for a few hours, the damage can be done. But in my experience even though this does happen occasionally it is not very common, and if you keep your position sizes reasonable, the occasional blow up won't hurt you. I used to sit at my computer all day but now I actually leave for hours at a time and I am still able to manage things, notwithstanding the occasional blip. I also have a watch-list on my phone that I can glance at.

In terms of managing the portfolios, I also use soft stop losses but as you say, it matters less. The goal there is to really just stay in the trend until it breaks down and since we are looking at the weekly time frame, we have more time to analyze and consider the chart action.

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