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Truths about stop-losses that nobody wants to believe

Newsletter , momentum , Stop-Loss , Back-test

I hated stop-losses! Mainly because some limited testing I did found that a stop-loss strategy lead to lower returns even though it did reduce large losses.

Nội dung chính

Truths about stop-losses that nobody wants to believeResearch study 1 – When Do Stop-Loss Rules Stop Losses?How was the stop loss applied?What they found it worked very wellResearch study 2 Performance of stop-loss rules vs. buy and hold strategyWhat they testedTrailing stop-loss resultsTraditional stop-loss strategy – not trailingWhat is the best stop loss strategy?Trailing stop loss is LOT betterResearch study 3 – Taming Momentum Crashes: A Simple Stop-loss StrategyWhat they testedTested over 85 yearsA lot lower lossesAnd higher returnsHelps you avoid market crashesDo you hate price driven stop loss strategies?Summary and conclusion – Stop-loss strategies workThe difficult part – your emotionsHow to implement a stop-loss strategyOf course it will not always workSystem that sells your losers to invest in your best ideasVideo liên quan

But you know here Quant Investing we look investment research all the time and I found three interesting papers that tested stop-loss strategies with results that changed my view completely.

But before we get to how and what stop loss you can use to increase your returns first the research studies.

Research study 1 – When Do Stop-Loss Rules Stop Losses?

The first research paper When Do Stop-Loss Rules Stop Losses? and was published in May 2008 by Kathryn M. Kaminski and Andrew W. Lo.

The paper looked the application of a simple stop-loss strategy applied to an arbitrary portfolio strategy (for example buying the index) in the US markets over the 54 year period from January 1950 to December 2004.

How was the stop loss applied?

The strategy used a simple 10% stop loss rule. When a 10% loss was exceeded the portfolio was sold and the cash invested in long term US government bonds.

Cash would be moved back into the stock market once the 10% fall in the stock market was recovered (the 10% stop-loss was recovered).

What they found it worked very well

The researchers found that when the model was invested in the stock market it gave higher return than bonds 70% of the time, and during stopped-out periods (when the model was invested in bonds), the stock market provided a higher return than bonds only 30% of the time.

So it worked.

Over the whole 54 year period the study found that this simple stop-loss strategy provided higher returns while the same time limiting losses substantially.

They also found that the stop-out periods were relatively evenly spread over the 54 year period they tested. This shows you that the stop-loss was not just triggered by a small number of large market movements (crashes).

If the researchers excluded the technology bubble (used data from Jan 1950 to Dec 1999) the model worked even better. This was because it got back into the stock market too quickly after the technology bubble crash.

This was most likely because the stop loss level was set too low. For a better stop loss level look the next research studies.

To find ideas that fit your investment strategy – Click here

Research study 2 Performance of stop-loss rules vs. buy and hold strategy

The second research paper was called Performance of stop-loss rules vs. buy and hold strategy, published in 2009 by Bergsveinn Snorrason and Garib Yusupov.

What they tested

They compared the performance of following a trailing and normal stop-loss strategy to a buy and hold strategy on companies in the OMX Stockholm 30 Index over the 11 year period between January 1998 and April 2009.

This is a short test period but it included the bursting of the internet and the financial crisis.

Investments were made on the first trading day of every quarter (starting January 1998).

When a stop-loss limit was reached, the stocks were sold and cash was held until the next quarter when it was reinvested.

What is really helpful is they tested stop-loss levels from 5% to 55%.

Trailing stop-loss results

The table below shows the results of the use of a trailing stop-loss strategy.

As you can see the highest average quarterly return (Mean = 1.71%) was obtained with a 20% trailing stop-loss level limit. The highest cumulative return (Cumulative = 73.91%) was achieved with a 15% trailing stop-loss limit.

The only stop-loss level that did worse than the buy-and-hold (B-H) portfolio, with a negative average return of 0.12% and cumulative return of -8.14%, was from a trailing stop-loss strategy with 5% loss limit.

Returns from using a trailing stop-loss strategy

Click image to enlarge

The following chart shows the total end value of all the strategies.

Trailing Stop-loss, equally-weighted total portfolio performance

Click image to enlarge

As you can see the 15% and 20% trailing stop loss levels give you about the same overall result with the 20% stop-loss level leading to higher returns most of the time.

Traditional stop-loss strategy – not trailing

The following table shows you the results if you applied a traditional stop-loss strategy, which means that you would calculate the stop-loss from the purchase price.

Returns from using a traditional stop-loss strategy

Click image to enlarge

As you can see all traditional stop-loss levels from 5% to 55% would have also given you better returns than the buy and hold (B-H) strategy.

The highest average quarterly return (Mean = 1.47%) was achieved the 15% stop loss level and the highest cumulative results of 57.1% the 10% stop-loss level closely followed by the 15% stop-loss level 53.31%.

The chart below shows you the results of the traditional stop-loss strategy for all tested stop-loss levels.

Traditional Stop-loss, equally-weighted total portfolio performance

Click image to enlarge

In the chart you can see that the 15% loss level would have given you the best result over the largest part of the 11 year test period.

To find ideas that EXACTLY fit your investment strategy – Click here

What is the best stop loss strategy?

So what is the better stop-loss strategy?

To find out I deducted the results of the traditional stop-loss strategy from the trailing stop-loss strategy.

The results are summarised in the following table:

Trailing stop-loss minus Traditional stop-loss

Click image to enlarge

Trailing stop loss is LOT better

Only the 5% and 10% stop loss levels did the traditional stop-loss perform better than the trailing stop-loss BUT the overall returns were bad.

At all other loss levels the trailing stop loss outperformed, most notably the 20% stop loss level where it performed 27.47% better over the 11 year period.

Research study 3 – Taming Momentum Crashes: A Simple Stop-loss Strategy

The third research study is calledTaming Momentum Crashes: A Simple Stop-loss Strategy by Yufeng Han (University of Colorado), Guofu Zhou (Washington University) and Yingzi Zhu (Tsinghua University) and was published in August 2014.

What they tested

The researchers applied a simple momentum strategy of each month buying the 10% of companies with the largest price increase over the past six months and selling short the 10% of companies with the largest price falls the past six months.

Once the stop-loss was triggered on any day the company was either sold (Winners) or bought (Losers) to close the position. Remember this was a long-short portfolio.

If a position was closed the proceeds were invested in the risk-không lấy phí asset (T-bills) until the end of the month.

Tested over 85 years

They applied this strategy over the 85 year period from January 1926 to December 2011 on all US domestic companies listed on the NYSE, AMEX, and NASDAQ stock markets (excluding closed-end funds and real estate investment trusts).

A lot lower losses

At a stop-loss level of 10%, they found that the monthly losses of an equal weighted momentum strategy went down substantially from 49.79% to 11.34%.

For the value-weighted (by the last month-end market value) momentum strategy, the losses were reduced from 65.34% to 23.69% (to -14.85% if August 1932 is excluded).

And higher returns

Not only did the use of the simple stop loss strategy reduce losses it also increased returns.

The stop-loss strategy increased the average return of the momentum strategy from 1.01% per month to 1.73% per month (a 71.3% increase), and reduced the standard deviation of returns from 6.07% per month to 4.67% (23% reduction).

It also increased the Sharpe ratio (measure of risk adjusted return) of the stop-loss momentum strategy to 0.371, more than double the level of the original momentum strategy of 0.166.

Helps you avoid market crashes

The stop-loss momentum strategy also completely avoided the crash risks of the original momentum strategy as the following table clearly shows.

Click image to enlarge

Note that if you followed a stop loss strategy you would have made a small profit when the momentum only strategy lost nearly 50% and 40%.

Do you hate price driven stop loss strategies?

Do you hate a price driven stop-loss system? If so you are most likely a hard core value investor.

Here is something you may want to consider, a fundamental stop loss suggested by a friend and long-term subscriber to the Quant Investing stock screener.

You can read the whole article here:

Ever thought of using a fundamental stop-loss?

Summary and conclusion – Stop-loss strategies work

This has been a long article to show you that stop-loss strategies work

As you have seen:

When applied to a 54 year period a simple stop-loss strategy provided higher returns while the same time lowering losses substantiallyA trailing stop loss is better than a traditional (loss from purchase price) stop-loss strategyThe best trailing stop-loss percentage to use is either 15% or 20%If you use a pure momentum strategy a stop loss strategy can help you to completely avoid market crashes, and even earn you a small profit while the market loses 50%Stop-loss strategies lowers wild down movements in the value of your portfolio, substantially increasing your risk adjusted returns

The difficult part – your emotions

The key to making a stop-loss strategy work is to stick to your plan, not once but over and over and over again.

The difficult part is to not let your emotion keep you from selling when a stop-loss level is reached.

How to implement a stop-loss strategy

This is how you can implement a stop-loss strategy in your portfolio, it is also the strategy we use in the Quant Value investment newsletter.

Implement a trailing stop-loss strategy where you calculate the losses from the maximum price the company has reached since you bought itOnly look to see if the stop-loss percentage has been exceeded on a monthly basis. If you look it daily you will trade too much and the costs will lower your returnsSell your investment if the monthly evaluation date the trailing stop-loss level of 20% has been exceededMeasure the trailing stop-loss in the currency of the companys primary listing. This means measure the stop-loss of a Swiss company in Swiss Francs (CHF) even if your portfolio currency is Euros or US DollarsReinvest the cash from the sale in the best idea that currently fits with your investment strategy. If you subscribe to the newsletter you would invest in the ideas you receive the month the investment is sold

Of course it will not always work

These studies all showed the success of a stop-loss strategy over long periods of time, this of course does not mean that a buy and hold strategy will not sometimes outperform your stop-loss strategy.

But over the long term it will reduce your portfolios volatility (large losses) and increase your compound investment returns. This will also help you stick to your investment strategy!

System that sells your losers to invest in your best ideas

What a stop loss strategy also does is it gives you a disciplined system to sell losing investments and invest the proceeds in your current best ideas.

PS Do you hate a price driven stop-loss system? If so here is an idea that will help you limit your losses if the underlying business of your investment starts to go downhill. Ever thought of using a fundamental stop-loss?

PPS To find investment ideas that EXACTLY fit your investment strategy click here

It is so easy to get distracted, why not sign up right now? It costs less than an expensive lunch for two and if you don’t like it you get your money back.

To find investment ideas that EXACTLY fit your investment strategy – Click here

Sources:

Performance of stop-loss rules vs. buy and hold strategyBergsveinn Snorrason and Garib Yusupov Spring 2009

Taming Momentum Crashes: A Simple Stop-loss StrategyYufeng Han, Guofu Zhou, Yingzi Zhu, August, 2014

When Do Stop-Loss Rules Stop Losses?Kathryn M. Kaminski and Andrew W. Lo May 1st, 2008

The Big Picture Blog – The Virtues of Stop Losses

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