Stops Hurt!

Last Updated on November 22, 2020 by Oddmund Groette

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Risk management is a very important factor when determining a strategy is profitable or not. Stop-loss is a much-used technique by traders. Put short, stop-loss is a limit where one simply liquidates the position at a certain level. Before entering a position, the max loss is determined, and if the trading vehicle reaches that limit, the position is closed. This is to limit the potential loss (because we never know how far the position can go against us).

Over the years I have run several thousand tests. My experience is that using a stop-loss deteriorates system performance quite much. I guess around 90% of my testing gets worse results when using stop-loss. Why? Usually, a stop gets triggered when the trading vehicle falls (if you’re long). Trading stocks or indices is not a good time to sell. Personally, I like to buy when prices fall, not sell. If you buy DAX at 6500 after a fall, and it falls further to 6400, it gets even more oversold and ripe for a bounce. Of course, it might fall to 5500 for all we know, but for the long term, it’s not smart to sell into situations like that. In the long term, it pays off to wait for a bounce. Even in sharp market declines, there are very powerful rallies, probably even bigger than in bull markets. It will pay off to wait for a bounce, especially if you’re trading market indices. When looking to trade overbought/oversold, stops generally don’t work.

Bear in mind that I trade mostly mean reversion strategies and short term strategies. If trading “trend” strategies the results might be different.

In Larry Connors book, Short-term Trading Strategies That Work, he dedicates a chapter to stops. The chapter discusses how Larry’s research team ran hundreds of tests to try and find optimal stop levels. In doing so they came to the conclusion that for the trades they were looking at, the optimal stop was consistently none at all. In every case, they found that instituting stops hurt system performance.

Curtis Faith came to the same conclusion, and he’s a trend follower. In Way of The Turtle he writes the following on page 145:

“Note that the zero case, which means no stop at all, has the best MAR ratio numbers. In fact, the test with no stops is better for all the metrics: CAGR%, MAR ratio, Sharpe ratio, drawdown, and length of drawdown – every single metric. The same things holds true for a test of the Triple Moving Average system: Every single measure was worse with any stops. The same test of stops applied to the Donchian Trend with time-based exit system yields similar results except that for very large stops of 10 ATR or more, the results are about the same as those for a test with no stops. This certainly goes against the common belief that one must always have a stop.”

If you know what you’re doing, you can ignore stop-loss. However, if you have little experience I think it’s smart to have a stop in place. The reason is most people will just hope for the position to turn around and be profitable if it goes against you. That way you risk a very big loss that can ruin your account. So if you’re inexperienced I think it’s wise to use stops to avoid havoc.

In a later article, I will write about alternatives to stop-loss.