The Strategy Behind Professional Traders Avoiding Stop Losses and Focusing on Risk/Reward Ratios

Many successful swing traders and momentum traders have successfully steered clear of using stop losses. Instead, they have focused on managing risk/reward ratios for each trade, a strategy that has significantly boosted their returns. In this article, we will explore the reasons behind this unconventional approach and discuss the potential benefits and pitfalls.

Why Professional Swing Traders Choose Not to Use Stop Losses

Professional swing traders overwhelmingly prefer to avoid using stop losses for several compelling reasons. The primary issue with standard stop loss orders is that they can prevent the trader from benefiting from the recovery of the share price in fundamentally strong companies. Let’s break down a few key points:

Fundamentally Strong Companies and Share Price Recovery

The most crucial aspect to understand is that the share price of fundamentally strong companies, such as Reliance, can fall, but it is highly unlikely to remain at a depressed level for an extended period. For example, if Reliance’s share price drops 20% from its lifetime high, it may seem to be in distress. However, history has shown that such companies have a remarkable track record of recovering and even surpassing previous highs.

This principle applies to all good companies, whether they are small-cap, mid-cap, or large-cap. Time and again, we have seen that the patience of the investors is rewarded. If the fundamentals remain intact, there is a high probability that the share price will recover and even outperform. Therefore, selling on the basis of a short-term decline does not align with sound business practice.

Support from Institutions and Promoters

Another important factor to consider is the presence of long-term investors, traders, institutions, and even the company’s promoters themselves. These entities typically believe in the long-term prospects of the company and are often positioned to buy shares at lower levels. They often have incentives to push the share price back up, recognizing the intrinsic value of the company.

This buying pressure can sometimes take a considerable amount of time to manifest. In rare cases, it can materialize very quickly. Hence, it is crucial to have patience as the recovery is likely to occur in due course.

Risk/Reward Ratios: A More Strategic Approach

Instead of relying on stop losses, many professional swing traders focus on the risk/reward ratio of each trade. This approach involves setting realistic expectations for potential gains and carefully managing the risk to ensure a positive outcome. Here’s why this strategy is effective:

Defining the Best Time to Enter

The risk/reward ratio helps traders determine the optimal entry point for a trade. By analyzing the potential return on investment, traders can enter the market at the right moment, knowing that their potential gains outweigh the potential losses.

Patience as a Core Component

Traders using risk/reward ratios rely heavily on patience. They understand that short-term declines are merely Technical adjustments and do not necessarily signify fundamental weaknesses. By holding through short-term volatility, traders can capture the full potential of the recovery, which is often more substantial than the initial decline.

Case Study: Reliance Industries

To illustrate the effectiveness of this approach, consider the example of Reliance Industries. When its share price dropped 20% from its lifetime high, many traders might have been inclined to sell. However, by understanding the company’s fundamentals and recognizing the support from long-term investors, one could have held onto the investment. Over time, the share price would have rebounded, potentially surpassing its previous high.

When to Consider Intraday or Options Trading

In contradistinction to swing trading, intraday and options trading typically require a different approach. These methods involve shorter-term strategies and require rapid decision-making. For these types of trades, stop losses are often more effective in managing risk, as the volatility is higher and more immediate reactions are necessary.

Conclusion

The decision to avoid stop losses and focus on risk/reward ratios is a strategic choice that aligns with a long-term investment perspective. For swing traders, patience, fundamental analysis, and an understanding of the support from long-term investors can lead to significant gains. However, it’s essential to recognize the differences in approach for different trading styles.

Remember, while this strategy has proven effective for many successful traders, every trading strategy carries its own risks. It is crucial to perform thorough research, understand the markets, and always be prepared to adjust your approach as market conditions change.