Some sort of loss control should be a requirement for traders in the financial markets. Losses need to be controlled whether someone is a short-term trader or a longer term investor. Yet, while many traders use a fixed stop to control losses and maintain discipline, there are certain trading styles that benefit from the use of a mental or soft stop. (For a background reading, see How Does A Stop-Loss Order Work?)
Mental or Soft Stops
A mental stop is when a computer order is not placed to exit a trade for us, but instead we leave the position open with no offsetting order to control our loss. A stop order is not placed, but the trader still has a level in mind where he or she will exit a losing position (or a winning position using a trailing mental stop).
A soft stop can also refer to a mental stop that is not at a fixed price. The trader may have a range of values in mind where he or she will exit based on market conditions.
For example, a trader may buy a stock at $25.15 and have a mental stop at $24.90. A stop order is not placed at this price; if the price moves to 24.90. the trader will execute a sell order to exit the trade. Conditions are constantly changing throughout the day so a trader may decide that they will exit in the area of $24.90 (higher or lower), but the exit depends more on what is happening in the market at that given moment than what was perceived as a good stop level at an earlier time. This is a soft stop.
Who Should Use Mental or Soft Stops?
Mental and soft stops require that a trader monitor the position in case losses increase toward the stop area. For this reason, mental and soft stops are commonly used by short-term traders, such as day traders. But mental stops can be used by longer-term traders as well, and can be used when positions are taken for fundamental reasons.
Short-term traders often implement mental soft stops as there are many short-term factors that can materialize throughout the day. For example, an order may go through that would trigger a fixed stop level, but the trader knows this is a short-term phenomenon, and thus the trade does not need to be exited. Day traders also often see stop runs (quick price spikes beyond even dollar amounts or price levels where there is generally a large quantity of stop orders), which run prices beyond support or resistance. However, if the technical or fundamental factors have not changed, this situation does not necessarily require an exit. (For more, see Day Trading Strategies For Beginners.)
Fundamental traders also benefit from soft stops because they don't need a stop at a set price; they realize prices fluctuate and as long as the fundamentals are pointing toward a profitable position, they can stay with the trade. Once fundamentals shift they should exit the position. (To learn more, check out Introduction To Types Of Trading: Fundamental Traders.)
Advantage of Soft Stops
There is an advantage to not having a fixed stop. One common frustration for traders is setting a stop level, then having that stop order triggered (and the position exited) only to see the stock quickly move back in their direction. This can be avoided by using a soft stop. Losses can be taken quickly if the trader sees there is likely to be a large pullback and doesn't want to hold the position through it, or the trader can give the position room to move by carefully monitoring what is happening in the market.
When a fixed stop is originally placed, it is based on the data that is available at the time of the trade. As new data becomes available, that stop can be adjusted so as not to be stopped out at a level where the market is likely to go before resuming course. Therefore, the main advantage of not having a fixed stop is that the trader is not automatically exited from positions based on old information; the trader is able to stay in positions that still show promise but are experiencing a short-term technical anomaly.
Many traders also make very quick trades or many trades in a day. Setting a fixed stop on each position is simply not possible. Therefore, if positions are taken for quick profit or require fast action, a fixed stop should not be set. The timed used for placing a stop order could result in an entry or exit being missed. (Learn more in Would You Profit As A Day Trader?)
Fixed stops do have many uses. They are used to limit losses to a certain amount, and it is possible that a soft stop will result in a larger loss than the fixed stop would have allowed. Mental soft stops require a large amount of discipline from the trader as they need to determine in real time whether a trade should be exited - this can be difficult when losing positions are involved. Another downside is that the trader must be able to monitor positions so they can exit the positions when factors indicate that they should.
Not all traders are able to monitor positions constantly, or may lack the discipline to exit positions without a fixed stop. Thus mental or soft stops should only be used by traders who possess these qualities.
The Bottom Line
Traders who are going to use soft stops should be aware of several things. First of all, soft stops can be used for exiting positions earlier than expected, and should not be used only to give a position more room. There are times when market conditions change and there is no reason to hold a position any longer. Second, soft stops should also be used to exit trades when the original entry criteria is no longer valid or has disappeared.
Also, if soft stops are going to be used the trader must be aware of upcoming events that could have a large impacts on his or her positions. These events include instrument-related events, such as company news when trading the stock market, or economic data releases. These events can result in large losses if positions are not monitored and risk is not adequately controlled.
Finally, it is also prudent to have a final stop-out price placed with a broker. In extreme cases, or if the trader is for some reason not available to exit a losing position themselves, the final stop is the absolute maximum a trader is willing to lose on the trade. The final stop acts as a safety net for the traders, preventing them from blowing their entire account. (For more, read The Stop-Loss Order - Make Sure You Use It.)