Getting out of a losing trade is never easy. This is especially so when a trader has experienced getting out of losing trades, only to see it reverse and turned into profitable trades. A few more times like this is enough to cause the trader to abandon any stop loss policy he has and adopt no stop loss.
With a leveraged financial instrument such as futures, the worst-case scenario is to hit a margin call, whereby the brokerage firm will close all opened losing positions and take all the losses.
For example, the starting capital in an account is $10,000. If the trader bought a standard crude oil futures contract, $100,000 in size, he will need to set aside 50% of this amount, i.e. $50,000 in his account. With a 50:1 leverage, the trader just need to set aside $50,000/50 or $1,000 as initial margin. There are 10,000-1,000 = $9,000 available now for opening new positions.
All brokers require a maintenance margin for each opened position. This is the maximum running loss to the opened position before the trader need to top up. If the trader is unable to top up, he is said to hit the margin call.
Each crude oil futures contract is equal to 500 barrels, and every 0.01 move in crude oil is equal to $50. Every 0.10 move in crude oil is equal to $500.
Suppose a crude oil futures contract is bought at $115 per barrel, and the broker maintenance margin is $500, the trader will need to top up when crude oil moves to 115-0.10 = 114.90. Since the account has $10,000, that means 10,000-1,000-500 = $8,500 is available now for opening new positions.
No Stop Loss
With no stop loss order, the account would be completely wiped out when crude oil moves down $2 to $113.
However, if the trader has a definite stop loss policy, getting out of trades whenever he loses 10% of his account, ie. $1,000, the crude oil futures contract will be exited at 115 – 0.2 = $114.80. With the remaining $9,000, the trade can identify another opportunity.
This is the advantage of using a protective stop loss order.