Wednesday, August 13, 2008

Stop losses - why bother?

In a recent CXO Advisory article based on a paper by Lei and Li on "The Value of Stop Loss Strategies" the conclusion was:

Over the long term, systematic use of stop losses in trading individual stocks does not enhance the level of returns, but certain trailing stop losses reduce trading risk (standard deviation of returns).

So should we abandon stop-losses and go back to buy-and-hold?

The key advantage of the stop loss is the ability to preserve capital by defining boundaries based on the unknown. From a psychology standpoint it avoids the hang-on-to-your-losers mentality and helps build a trading routine which can be adapted as needed. Lei and Li did note the importance stop losses play in reducing trading risk.

In our strategy labs we have seen how different stock groups and different trading strategies behave under different fixed stops. The more volatile a strategy the better it may perform when a broader stop is used. But the broader the stop the greater the psychological risk of such a strategy.

When a tighter stop strategy is used the cost of commissions becomes a factor; directly as part of the price-loss strategy or indirectly from the increased number of trades.

A good example of how stops alter the performance of a strategy was found in our MACD strategy. The basic strategy 'bought' a MACD trigger bull signal and 'sold' a MACD trigger bear signal. The time frame was 7 years and comprised 17 stocks.

With a $9.95 commission:

  • The basic strategy without a stop generated 506 trades with a profit factor of 1.18 on a 43% win percentage
  • When an 8% stop was layered on to the strategy the number of trades lept to 814 (a 60% increase). The profit factor dropped to 0.92 and the win percentage fell to 36%
  • Bringing the stop to 3% increased the number of trades by a further 41% to 1149, dropping the profit factor down to 0.82, but leaving the win percentage at 36%

    With no commission:

  • The basic strategy generated 505 trades, but the profit factor jumped to 1.34 with a 46% win percentage
  • Using an 8% stop kept the number of trades at 814 but the profit factor was a positive 1.11 on an improved 39% win percentage
  • Tightening the stop to 3% increased the trades to 1149 as before. But without the penatly of commission the profit factor improved to 1.2 (better than the 8% stop strategy) with a 42% win percentage.

    The return using a MACD trigger 'buy' with a 3% stop was respectable, but only in a no commission environment.

    So even with this simple comparison there is considerable difference in the behaviour and returns of a strategy depending on the risk threshold adopted, but also the trading platform employed (be it zero commission or commission based).

    Stops have their place, but its not a simple matter of picking one and rolling with it. The risk management strategy has to sync with the nature of the profit strategy as dictated by the trade entry signal and the costs of such a trade.

    Buy-and-hold may be as good as a stop-based strategy, but is this the kind of comfort you want heading into the unknown?

    Dr. Declan Fallon, Senior Market Technician, the free stock alerts, market alerts, and stock charts website