Welcome

This is a site for investors and traders of all experiences and all backgrounds. My intent is to make concepts understandable for the novice investor as well as the experienced trader. The mission is to educate the investing public by bringing to light vital tools and information necessary to make money in the stock market.



Our 6 to 12 month outlook in the stock market: Positive

Tuesday, April 19, 2011

Stop Losses - Help or Hindrance?

In the past 15 or so years that I've been developing trading systems I have dabbled in using stop losses. I was never able to use a stop loss method that enhanced my overall return/risk performance. So inevitably, I stopped using a stop loss when investing.

The other day I was fortunate to come across an article written by Dr. Bruce Vanstone. He recently came out with a new book, Designing Stock Market Trading Systems. In his article he discusses his research on stop losses, and whether or not they are a help or a hindrance. I would like to share it with you. The following is an excerpt from Dr. Vanstone's article:

Trailing Percentage Stops

Many traders and investors place stop loss orders as part of their day-to-day investment activity. Virtually all trading books recommend the use of stops, with many making statements like 'Trading without stops is like driving without a seat belt'. The argument for the use of stop-loss rules seem inherently sound, yet there appears to be no real evidence that stops are providing the safety benefits that many traders expect.

With regard to medium to longer term equity trading systems (which appears to cover the majority of investors and traders), it may well be that stops are causing more harm than good!

As traders, we are used to having an initial stop loss on a trade, and congratulating ourselves when the stop saves us money as the trade goes south very quickly. Although a stop-loss rule may save us from damage on specific trades, it seems doubtful whether this beneficial effect actually holds when we measure it at a portfolio level. There are a number of specific reasons why this may be the case.

As traders, we shouldn't really focus on the return of each individual trade; rather we should focus on the overall return of our portfolio. A large amount of my empirical testing appears to show a mismatch between stop performance at an individual trade level, and stop performance at a portfolio level.

Many traders and brokers use an initial percentage stop and a trailing percentage stop to manage their position. As an example, a trader might say, 'I will set a stop loss 5% below my entry price, and then trail it 5% below the previous days closing price as the trade progresses'. Here, we test this method using percentage thresholds from 1% - 10% in steps of 1, for all the trades generated by the EMA crossover rules.

The impact that these percentage trailing stops have on both return and risk is presented next:

Initial Stop Loss Setting/ Daily Mean Return ($)/ Average # of Open Days

NO STOP LOSS/ 0.61 /21.44
1% Trailing Stop Loss/ -14.12 /3.25
2% Trailing Stop Loss/ -8.91 /5.64
3% Trailing Stop Loss/ -5.62 /8.69
4% Trailing Stop Loss/ -4.18 /10.96
5% Trailing Stop Loss/ -3.41 /12.67
6% Trailing Stop Loss/ -2.67 /14.08
7% Trailing Stop Loss/ -2.03 /16.08
8% Trailing Stop Loss/ -1.55 /17.53
9% Trailing Stop Loss/ -1.24 /18.79
10% Trailing Stop Loss/ -0.94 /19.41


From the table presented, it is clear that none of the stop methods tested improved the 'NO STOP LOSS' portfolio's daily mean return. This is as expected, given that, an initial stop loss rule entails selling at a loss. To determine whether this approach has decreased our risk, we next test within a portfolio setting.

Portfolio

Initial Stop Loss Setting/ APR (%) /Max DD (%)/ Sharpe Ratio

NO STOP LOSS/ 2.63/ -34.63 /0.31
1% Trailing Stop Loss/ -9.28/ -61.95 /-2.00
2% Trailing Stop Loss/ -8.11/ -57.14 /-1.78
3% Trailing Stop Loss/ -6.31/ -49.71 /-1.22
4% Trailing Stop Loss/ -6.12/ -49.30 /-0.98
5% Trailing Stop Loss/ -5.87/ -48.81 /-0.84
6% Trailing Stop Loss/ -4.95/ -45.24 /-0.62
7% Trailing Stop Loss/ -3.39/ -37.32 /-0.42
8% Trailing Stop Loss/ -2.09/ -34.92 /-0.23
9% Trailing Stop Loss/ -1.68/ -29.04 /-0.21
10% Trailing Stop Loss/ -1.37/ -36.78 /-0.12


From this table, we can see that none of the stop methods have improved the 'NO STOP LOSS' portfolio's APR. Further, none of the stop loss settings was able to improve the Sharpe Ratio. Again, all combinations of stop loss tested achieved less returns, ans were riskier.

Implications

To statistically compare the portfolio results, we can use the ANOVA procedure, which allows us to simultaneously compare all the trades generated under the 'NO STOP LOSS' condition, with all the sets of trade possibilities from the 10 stop loss combinations. This allows us to determine whether there is any statistical significance in our findings.

The results indicate that no benefit has been obtained from any of the stop combinations. I have purposefully omitted a detailed explanation of using the ANOVA procedure in this article, to allow us to keep focused on the effects of stop losses. Those interested in pursuing the benchmarking of trading systems using statistical methods can find all the details in my book.

Summary

I have continued testing different types of stops to see if they can improve the original crossover strategy. It was found that all stops tested (for example, percentage and ATR) increased the risk and reduced the return of the original strategy.

Thursday, January 13, 2011

The Number One Rule For Successful Investing

Do you have what it takes to make money in the stock market? Consider the following excerpt from Tharps, 'Trade Your Way To Financial Freedom':

'Perhaps the number one rule for trading is to cut your losses short and let your profits run. Those who can follow this simple rule tend to make large fortunes in the market. However, most people have a bias that keeps them from following either part of this rule.

You must pick one of two choices in the following example:

Which would you prefer: (1) a sure loss of $9,000 or (2) a 5% of no loss at all plus a 95% chance of a $10,000 loss?

Which did you pick, the sure loss or the risky gamble? Approximately 80% of the population picks the risky gamble in this case. However, the risky gamble works out to a bigger loss. Taking the gamble violates the first part of the key trading rule - cut your losses short. Yet most people continue to take the gamble, thinking that the loss will stop and that the market will turn around from here. It usually doesn't. As a result, the loss gets a little bigger and then it's even harder to take. And that starts the process all over again. Eventually, the loss gets big enough that one becomes forced to take it. Many small investors go broke because the cannot take losses.

Now consider another example:

Which would you prefer: (1) a sure gain of $9,000 or (2) a 95% chance of a $10,000 gain plus a 5% chance of no gain at all?

Did you pick the sure gain or the risky gamble? Approximately, 80% of the population picks the sure gain. However, the risky gamble works out to a bigger gain. Taking the sure gain violates the second part of the key rule of trading - let your profits run.

People, once they have a profit in hand, are so afraid of letting it get away that they tend to take the sure profit at any sign of a turnaround. Even if their system gives not exit signal, it is so tempting to avoid letting a profit get away that many investors and traders continue to lament over the large profits they miss as they take sure small profits.'