I tend to be pretty paranoid about risk of ruin. That is why I almost always suggest adding some form of stop-loss protection to the systems I write about. It just makes sense to me that you should do everything possible to protect your trading capital.
Some of the strategies I have profiled seem to leave themselves open to holding large losing positions. My simple solution to this problem is always to add a simple stop-loss component. However, that could be detrimental to the overall performance of the system.
A recent guest post on System Trader Success forced me to take a deeper look at whether stops are actually worth using. The post was written by Rob Hanna from Quantifiable Edges.
The logical idea of adding stops to reduce your risk of ruin my actually hurt your system’s overall performance.
Rob explains that he primarily trades mean reversion strategies similar to the ones that Larry Connors has published in his books. He explains that Connors has written about the tendency of stops to reduce overall performance. Rob has done his own research on the topic as well:
When looking to trade overbought/oversold techniques, stops generally don’t work well.
If the system suggests the security should bounce when it drops to $20 and it continues to $18, then it is REALLY overdue for a bounce. Any level of stop ensures you are selling an extremely oversold security that is making a low.
Those are buying conditions for oversold systems – not selling conditions.
The trend following crowd won’t agree with what Rob is saying about a security being “really overdue for a bounce,” but it will make sense to mean reversion traders. Rob also points out a stop strategy that seems to have the least negative impact on his oversold systems:
Wait until the security bounces for a bar or two. Look for a higher high, higher low, and higher close – or at least 2 of those 3.
Then place a stop under the swing low that was just made. In cases like this even if the security doesn’t hit your target exit price, it still ensures that you won’t have to suffer through the entire next leg down.
While it seems logical and can sometimes help avoid catastrophic trades in the long run, you’re normally better off just waiting for the mean reversion to occur and exiting at your target level.
He also makes the point that position sizing is extremely important and suggests using options to place trades instead of stops:
Not using stops does not equal not controlling risk. Position sizing becomes very important.
Traders could also consider using options to trade their short-term positions. Options provide a natural stop (zero).
Rob closes his piece by reminding us that he is specifically talking about mean reversion systems. He agrees that stops can be very effective when used with trend following systems.
The interesting take-away from this piece is that the type of strategy you are trading should be what influences your choice of stop-loss strategy more than your personal risk tolerance. If you are struggling with the risks your system takes, changing strategies might be a better option than adding stops.
The post Contemplating Stops: Are They Hurting Your System? appeared first on Quantitative trading blog.