Using Mental Stops in Trading
Using a mental stop means getting into a trade, identifying a price at which you would like to exit in order to cut your loss and then waiting for the market to hit or at least get close to that price before actually placing your order in the market place. Another approach is to wait for a certain set of exit criteria to be met and then entering an order to exit the trade at that time. Mental stops are popular with traders who used to place open stop-loss orders but got sick of seeing their stops get hit just before the expected trend resumed. This type of stop is also used by large traders who don't want an open order to buy 100 T-Bond contracts sitting in the market place for fear that someone might get wind of it and "run their stop."
While mental stops can at times allow you to avoid "whip-saws," they do have one serious and (for many traders) potentially deadly fault. Consider the situation you put yourself in when you decide to use a mental stop. What you are saying is that "at the worst possible moment—when the pain of losing money on a given trade becomes too great—I will absolutely, positively pick up the phone, call my broker and place an order to stop myself out." Many traders feel that they are up to this challenge. And many traders are up to this challenge, except for that one time when they just know they are right, that the market is going to reverse at any moment, and that if they just wait a little bit longer and give the market just a little more room, then they won't have to suffer a big loss and everything will turn out OK.
The problem with putting yourself in this situation is that the scenario just described is exactly how a lot of losing traders go belly up (including losing traders who were winning traders as little as one trade prior). That one bad trade, when they just could not pull the trigger, does them in. If you have never witnessed this happen to someone, just picture standing next to your best friend while his or her house burns down and then you will get the idea. Mental stops, while perfectly logical and at times highly effective, are an invitation to disaster.
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