Advantages and Disadvantages of Stop Losses In Spread Betting

Anyone who knows anything about spread betting knows that stop losses are absolutely essential. If you trade without stop losses your taking the worst kind of risk which I like to call "blow up risk". You can of course only blow up once so, regardless of how many wonderful trades you've made if you make one single dumb mistake and leverage it 10:1 or 20:1 then your account can be wiped out. Hence stop losses are simply essential.

However, stop losses do have important disadvantages and problems that you should be aware of. This is not so you can abandon them or start trading without stop losses (that would be very stupid). The reason you need to understand the problems with stop losses is so that you can manage and minimise these. If you don't use stop losses correctly you will struggle to make money (though you won't be wiped out).

Advantages 

• Protects you from blow up risk 
• Helps you manage your portfolio by quantifying your maximum exposure 
• Makes your portfolio more fragile (see the work of Nassim Taleb)
• Can reduce margin requirements

Disadvantages 

• Your effectively shorting the volatility in the stock. If the trade moves against you because of volatility (i.e. not fundamentals such as news or earnings) you will be forced out at a loss. You therefore need a sensible stop distance that takes into account the volatility in the stock. For example if you were short a small cap oil stock (for example, Afren Plc) you would need to have a very large stop distance and sufficient financial strength to withstand large losses as you wait for your thesis to become true (note, it may never). 
• Stop losses incur commission (or a wider spread) which increases your total cost and reduces your profits proportionally.
• May fail to execute or be delayed 
• Guaranteed stop losses increase the spread and therefore cost more. Furthermore, they are not available on all stocks.  

Hopefully you now have a better understanding of how stop losses work and can now start to think about how to mange their downside. Fundamentally what you ideally want is a stop loss that doesn't get triggered by volatility but protects you from big adverse random events (black swans) or just being totally wrong. Unfortunately, even though stop losses are extremely important they are pretty annoying for all the reasons mentioned above.

I also hate how you have to pay to effectively mange risk. I would have thought brokers would want to prevent blow ups. However I expect they are making so much money from the spread that it works out well for them.