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.
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