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.

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.'

Market Anomaly

At my firm I back-test, back-test and back-test... and when I feel okay about a new approach I back-test some more. Here's an interesting anomaly that I found the other day. You can put it in your trading arsenal. This isn't a 'stand alone' system, but nonetheless, it is rather impressive.

Did you know that on the closing bell of the 3rd Friday of July, August, September and October, the S&P 500 loses -17% (over the next 5 days) on an annual rate since 1942? With everything being equal, one should either, exit their 'long' positions or open a 'short' position during these periods.

An Investor's Biggest Mistake

An investor's ego is the major reason why beginning traders are drawn to discretionary trading. Discretionary trading feeds the ego; it is trading that relies on one's judgement, in contrast with systematic trading, where trading decisions are made by using rules that specify exactly when and how much to buy and sell. So when you use your judgement to trade and you win, the ego wins. You can brag to your fiends how you are the master of the markets.

I see this particular behavior constantly on online trading forums - especially the broad-based ones that attract new traders. You regularly see posts from individuals bragging about how they bought just before the run-up, or they have found the Holy Grail and have 90% accurate system, or they have been trading for three months and have made 200%. They invariably have done this by trading with too much leverage. A few months later you may see the same trader post that they have blown up their account and lost everything. These individuals were trading to feed their egos, and as the saying goes, live by the ego, die by the ego.

Presidential Election Cycle System

The Presidential Election Cycle System was first published by Marty Zwieg in 1986. Simply and somewhat amazingly, the S&P 500 had a winning year each year preceeding the presidential election since 1942.

Since 1942, if you were to have placed money in the S&P 500 at the beginning of January on the year preceeding the Presidential election, and sold at the end of that year, you would have made an average of 16.66% return on your money.

With all the mixed news in the media, it makes it difficult to feel confident in which direction the market is headed. I can admit that the fundamentals of the economy do not look too rosey, and would expect 2011 do be a difficult year. However, according to the Presidential Election Cycle System, investing in 2011 seems to be a wise decision.

Bottom Fishing

This is a very simple phenomenon that all investors should be on the watch for. It doesn't happen often, but when it does, this strategy allows you to get in the market very early and at a low price.

The logic behind this strategy has been around for a long time and is detailed in the book "Trade like a Hedge Fund" by James Altucher. He makes a common mistake of using repeat signals in his analysis, so I use a hybrid of this strategy.

When the S&P 500 closes 20% below the S&P 500 200 day moving average, the investor places a buy order in an S&P 500 exchange traded fund (ETF). Hold the position for 20 trading days.

This strategy will fire a buy signal in the midst of panic selling. Therefore, this strategy is perfect for call options as it will generate a buy signal when almost no other system will. Everyone will be bearish and buying put options to protect themselves against further weakness.

I ran a historical analysis dating back to 1960 and the results are as follows:

Total Trades: 16
Winning Trades: 75%
Largest Gain: 14.34%
Largest Loss: -9.73%
Percent Invested: 2.67%

Stock Market Seasonality

The stock market has very important seasonal tendencies that every investor must know. December and January are far and away the best months of the year for the stock market. Actually, a very bullish period of the year runs from November to early January.

September is easily the worst month of the year. Surprisingly, the next worst month of the year is February, as the stock market has seen many major tops occur in January. October, which many investors are deathly afraid of is in the middle of the pack as far as performance is concerned.

Don't miss these tendencies. These are based on over a half a century's worth of stock market history. Why they occur is really unimportant, but they do make some sense.

Since the stock market has a historical upward bias, at the end of the year many investors will have gains in their positions. If they can put off selling these profitable positions until the next year, they can put off the capital gains tax that they owe for a year. This reduction in selling during December could be the reason for the December/January bullishness.

The Pre-Thanksgiving Buy Signal

Here's an example of a market timing strategy that has worked for decades. It's very simple. You Buy the S&P 500 on the Monday before Thanksgiving and Sell the 3rd day of January.

Using the Rydex Nova mutual fund (beta = 1.5), I have back tested 54 years using this simple strategy and the results are as follows:

- Trades: 75% of the trades made money
- Maximum Drawdown: -13.9% vs the S&P 500 with -48%
- Total Gain: +13,285%
- Compounded Annual Return: +9.2%
- Tim Invested: 11.1% of the time

Investment Lessons from an Expecting Father

It's been a long time since I've updated this site. I have found myself so busy that I regret to say that my posts have fallen to the wayside. In an attempt to provide helpful information to investors I will continue to post; however, on a limited basis. Nonetheless, I believe that the information I provide will last the test of time and will be a valuable resource for those who want to manage their investments better.

On another note, I am happy to say that Diane and I are expecting our first child. We are expecting in May of 2010. We just had our 18 week ultrasound and I am happy to say that our little baby boy is healthy. It's been such a miracle because we were told we wouldn't be able to have children and yet we didn't need the help of modern medicine to do so.

There are many lessons that I have learned from investing, but there are 4 that stand out to me. Matching your personality (strengths and weaknesses) against a particular trading approach is very important. Once you apply and understand this, these lessons will come in handy.

1. Keep your system simple stupid. I have created many programs in my day and I have found that the simple systems hold up better over time than the more complex ones.

2. Execute your system consistently... even when your system is losing money in the market. If your system has positive expectations (positive back-tested results), you will only have positive results if you follow it. I often see investors take a 10% loss (when his/her system indicates to hold the position) just to see their exited position make 20%.

3. Control your risk so you can continue to trade or your account may not be around long enough to benefit from the positive expectation of your system.

4. Find a trading strategy that produces positive returns over the long run.

Happy holidays and happy investing.

How To Exit With Profits

Okay, you've placed a position in the market and you're making money. Alright, when do you decide to take your profits? Here's an example of a simple strategy to help you decide when you should exit your position.

To illustrate, if you're 'long' and the market hits a 21-day low, you exit. If you're 'short' and the market makes a new 21-day high, you exit. This stop is recalculated each day and it is always moved in your favor so as to reduce risk or increase your profits. This exit strategy produces above-average profits when traded with sufficient money.

Be aware that this exit strategy can far and away make you more money than the buy-and-hold approach. Drawdowns can be significant using this approach; however, position sizing and diversity can significantly reduce drawdowns.

Forget About Buying and Holding

The strategy of buying stock when the price crossed above the 1-year average and selling it when it crossed below that average outperformed a buy-and-hold strategy by a large margin.