Stop Loss Reality Checks That You Need to Know

Is stop loss necessary? Despite talks about the drawbacks of trading with stop loss, the following facts may prove otherwise.

Stop loss is a strategy to set an order to protect traders against further losses. It is implied that one must understand the fundamentals of what they trade so that they can spot the perfect opportunity to enter the market at the right moment. When they add a stop loss to the scenario, however, they are forced to recognize actual losses despite the possibility of the price moving back in the previous direction.

This is why there's an ongoing debate about the importance of stop loss. Is it wise to always use it considering its nature to stop orders when the price is just corrected? On the other hand, does it worth the risk of losing all your funds just to wait for the price to move back in your desired direction?

Surprising Facts about Stop-Loss

Many traders dedicate hours to establishing what they think to be the ideal entry point, but only a few devote the same amount of time to developing a sound exit position. This experience results in traders being correct about the market's direction but missing out on significant returns since their trailing stop was reached before the market surged or broke in their direction. Since traders typically place these stops based on a chart formation, they are frequently hit early. How so?

Some people believe that the market makers can see the market orders. When market makers see your order, they're believed to frequently "run the stops". Market makers know that amateurs who use stop loss orders prefer round numbers or visible support and resistance levels, so they usually wait around the area to go against the amateurs; when the amateurs' orders are automatically closed by the stop loss order, it would provide enough liquidity for market makers to profit from their trades at the best price. This is what everyone calls stop loss hunting.

Apart from that particular scheme, there are a few other surprising facts that you need to know about stop loss:

1. Stop Loss Increases Returns

In May 2008, Kathryn M. Kaminski and Andrew W. Lo conducted research on stop losses. A primary 10% stop loss mechanism was utilized in the project. They evaluated how a simple stop-loss strategy applied to an arbitrary portfolio performed in the US markets, using the price data between January 1950 and December 2004.

They presented a simple analytical methodology for determining the value contributed or subtracted by the stop loss rules, which are predetermined levels that limit a portfolio's exposure to a particular threshold of cumulative losses. They gave an empirical examination of stop loss rules applied to a buy-and-hold strategy on index futures contracts using daily futures price data.

When the portfolio's loss reached 10%, the transaction was closed and the investments were allocated to long-term US government bonds. Once the stock market's 10% drop had been recovered, the cash would be moved back into the market.

Kaminski and Lo later found that the stock market outperformed bonds 70% of the time when the stop loss model was applied and that the stock market outperformed bonds just 30% of the time when the model was used in bonds during stopped-out periods.

The research showed that using a basic stop loss technique offered higher returns while decreasing losses significantly. They also discovered that the stop-out durations were evenly distributed among the 54 years of data used in the project. This research demonstrated that stop loss was not triggered solely by a few significant market fluctuations.

2. Trailing Stop Loss is Better than Normal Stop Loss

Stop loss orders have long been thought of as a technique to preserve against losses. However, this method can also be used to lock in gains. In this case, stop loss orders are sometimes referred to as "trailing stops". Many active traders can keep going by employing initial stop loss protection and trailing stops to break even or lock in profits.

As the price swings, the stop loss level would be adjusted following the movement. So, using a trailing stop lets profits run while ensuring that at least some gain is realized should the price suddenly change direction.

How to set the trailing stop loss? In some platforms like MetaTrader, trailing stop loss can be adjusted in pips value so that the stop loss level would move following the price movement in said value. For instance, setting trailing stop loss at 20 pips would automatically move the stop loss 20 pips above the previous level when the price also prints a 20-pip movement in the direction that supports your order.

According to the research conducted by Bergsveinn Snorrason and Garib Yusupov in 2009, trailing stop loss is much better than the traditional stop loss. This research compared the performance of trailing stop loss and normal stop loss on the OMX Stockholm 30 Index price for over 11 years between January 1998 and April 2009.

Normal stop loss levels ranging from 5% to 55% produced better results than the buy-and-hold strategy. The 15% stop loss level had the highest average quarterly return (Mean = 1.47%), and the highest cumulative result of 57.1% is recorded by the use of 10% stop loss level; it is closely followed by the 15% stop loss level that produced a 53.31% return.

The Portfolio's Performance with Traditional Stop Loss 

Meanwhile, a 20% trailing stop loss could achieve a higher average quarterly return (Mean = 1.71 percent). With a 15% trailing stop loss limit, the maximum cumulative return (73.91%) was attained. A trailing stop-loss strategy with a 5% loss limit was the only stop loss level that performed worse than the buy-and-hold (B-H) portfolio, with a negative average return of 0.12% and a cumulative return of -8.14%.

The Portfolio's Performance with Trailing Stop Loss 

The conclusion is, the average stop loss performed better than the trailing stop loss only at the 5% and 10% stop loss levels, but the total returns were poor. However, trailing stop loss achieved excellent results at all other levels, most notably at the 20% level where it performed 27.47% better on the 11 years' worth of data.

3. Stop Loss Elevates the Momentum Strategy

In August 2014, Yufeng Han (University of Colorado), Guofu Zhou (Washington University), and Yingzi Zhu (Tsinghua University) performed a research project called "Taming Momentum Crashes: A Simple Stop Loss Strategy".

The momentum strategy is a trading method in which investors purchase rising stocks and sell them when they appear to have reached their top. The idea is to work with volatility by looking for opportunities in short-term trends.

The researchers used a basic momentum strategy in which they bought 10% of firms with the highest price increases in the previous six months and sold 10% of companies with the most significant price decreases in the previous six months. The company was either sold (Winners) or acquired (Losers) to close the position once the stop loss was triggered on any given day. It is noted that the strategy used in the research was a long-short portfolio. If a position was closed, the proceeds were invested in a risk-free asset until the end of the month.

The researchers used the method on all US domestic companies listed on the NYSE, AMEX, and NASDAQ stock exchanges, using their historical prices from January 1926 to December 2011 (85 years period).

The stop loss strategy raised the momentum strategy's average monthly return from 1.01% to 1.73%, accumulating a 71.3% gain while lowering the standard deviation of returns from 6.07% to 4.67%. The researchers concluded that the stop loss momentum strategy avoided the crash problems of the original momentum strategy.

Conclusion

Stop-Loss might not always work. However, it will lower your portfolio's risk and boost your compound investment returns in the long run. This strategy will also assist you in sticking to our investing plan. If your doubts on stop loss sprout from the risk of being stop hunted, you can avoid it by not setting stop loss levels at obvious areas; it is highly recommended to set it a few pips above or below the round numbers or certain support/resistance levels.

In addition, you don't have to worry about the stop loss preventing you to profit from the market if your strategy has been tested and proves to generate good profits in the long run. Regretting stopped orders would just lead you to uncertainties that may cause you to overtrade and deviate from your trading plan.

Last but not least, if the average stop loss strategy does not suit you, you can consider using the trailing stop loss strategy instead of the normal one. You only need to make sure that this feature works best in the trending market, so don't rely much on trailing stop loss in a range-bound market.