Mental Stops or Automatic Stops?

Mental stops call for greater maturity and finesse than automatic stops. Mental stops in the wrong hands is a very dangerous weapon. For instance, some currency pairs can sprint 200-300 pips in the blink of an eye, and an inexperienced trader who tries to replicate such a method without the required mindset and/or experience will very quickly learn some extremely harsh lessons.

To summarize, while it's important to see stops as a measure of risk control, it's different than controlling the risk by sizing the position or even managing an open position. Many people believe that knowing where to place protective stops constitutes money management, perhaps because of lack of information or unwillingness to delve into issues related to managing risk.

Although stops are an indispensable tool to protect our capital, the placement of stops is just a part of risk management. If a trader applies, for example, a stop loss of 200 pips on each of his positions he is pursuing a strategy that is absolutely not related to his total available capital or equity: you can not categorize that measure as money management.

What Is a Mental Stop Loss?

Normally when you set a stop loss you place it on your platform where your broker can see it. A mental stop loss is a stop loss, that you do not actually set on your platform to automatically close your trade.

Imagine you enter long on GBP/JPY at the 145.00 level. The way I trade, the maximum amount of pips you want to risk is 50. You can either set a stop loss that automatically closes you out at 144.50 or you could use a mental stop loss. However, with a mental stop you have to be there to monitor the trade because instead of setting an actual stop on the platform you will set an alarm to ring where you have set you mental stop loss. When your alarm rings you go back to the computer and monitor the trade closely so you can decide whether or not closing out is a good idea.

Setting a Mental Stop

There are a few things you have to do.

1. Figure out what you plan to risk on the trade

2. If you’re not going to be monitoring closely set a price alarm about 10 pips before your max risk level.

That is pretty much it. You want the price alarm to ring a little before the level is reached. If it’s moving down fast you do not want it to fly right past your max risk level. Obviously, the amount of pips between your max risk level and your price alarm is dependent on your situation. If you’re going to be in bed you would likely need more warning. If instead you’re going to be surfing YouTube you need less of a warning.

If you are going to be watching your trade like a hawk the alarm is obviously not needed.

Are Mental Stops for you?

I think mental stops can give intermediate and advanced traders an advantage in their trading. Using mental stops allows you to better manage your trades. Inevitably, there are times the price will move against your trade. However, everything clearly indicates that it is a temporary set back and you know it will likely move back in your direction. At times like this, if you have a set stop loss you will be taken out automatically. If you’re using a mental stop loss you can stay in the trade and allow it to move back in your direction. Of course, this could also work against you as I will discuss next.

If you’re a newbie trader, mental stop losses could be a hindrance. I think you need to be at a certain level before you begin using mental stop losses. You need to be able to properly read the market. If you cannot read the price action, and anticipate what will happen next, you are better off with solid stop losses. However, there is something you can do to expedite the learning process so you can begin benefiting from mental stops too. I will discuss that a little later though.

 Benefits of Mental Stops

Mental stop losses allow you to think before the trade is closed. I have always maintained that the more a trader uses their brain in their trading the better off they will be. On the other hand, the more they rely on their computer to do their work for them the worse off they’ll be. Computers (at least your standard PC or laptop) do not have the ability to read price action and weigh risks. When you give a computer a task it carries it out blindly and without question.

When you set an auto stop, your computer will close you out if the stop is reached. It will not look at price action and consider keeping the trade open because it anticipates the drawdown to be temporary. You, however, can take several factors into consideration and decide to keep the trade open. In the long run, this can save you a lot of pips.

So using mental stops can:

1. Save you from being stopped out of a good trade

2. Protect against stop hunting. Yes some brokers do stop hunt but if your stoploss is mental they cannot hunt it.

3. Allows you to properly think through whether or not it’s time to exit a trade.

At times I will have a trade break a S+R line, and then move against me. For example, a new report can be released that pushes the price against me temporarily. On some of these trades, I can tell by looking at price action that it will likely head back in my direction. If my stop loss is mental I have time to analyse the market and decide whether or not keeping the position open is viable.

 Drawbacks of Mental Stops

The drawbacks of mental stop losses are obvious. There will be times when you will lose more than your max risk on the trade. Your mental stop loss could be hit and you may decide to stay in as you believe it is only temporary drawdown. However, the price can keep moving against you. I consider myself an advanced trader and this still happens to me. It cannot be avoided but overall mental stops save me more pips than they cost me.

This is why I suggest only intermediate to advanced traders use mental stop losses. You have to be able to:

1. Handle losses: If you cannot handle losing you may just stay in as it moves further and further against you. You have to have the psychological experience to be able to cut a bad trade lose.

2. Read price action: If you cannot read price action yet you should not use mental stop losses. The ability to read price action is essential to using mental stops. The concept of mental stops is based entirely on the trader’s ability to judge whether or not the drawdown is temporary.

If you’re a newbie please steer clear of mental stops. Set auto stops until you learn to handle losses and read price action. Being able to read price action is something that grows with experience so just be patient and keep trading.