Comments on: Stop Loss Discussion http://www.thestockbandit.net/2008/04/20/stop-loss-discussion/ Trading blog with trading insights, discussion on swing trading, day trading, and trading psychology. Fri, 16 May 2008 09:59:57 +0000 http://wordpress.org/?v=2.0.9 by: TheStockBandit http://www.thestockbandit.net/2008/04/20/stop-loss-discussion/#comment-73313 Wed, 14 May 2008 12:14:15 +0000 http://www.thestockbandit.net/2008/04/20/stop-loss-discussion/#comment-73313 TSR, Thanks for your comments here, you bring up some excellent points. I think that a hard stop is particularly best for those who lack the discipline to pull the trigger in the heat of battle. But you're correct, knowing when to get out is the most important aspect here. It is funny how the money management topic tends to lose some people and you get that glazed-eye look when you start to discuss it, but you're absolutely right in that several small losses are easily covered by the occasional big win. I think of a good poker player folding, folding, folding and then winning a nice sized pot, so that's the analogy I've used most frequently. I have also seen traders with that 99% win rate who, oddly enough, are no longer trading ;-) Trade well today and thanks for your comments! Jeff TSR,

Thanks for your comments here, you bring up some excellent points. I think that a hard stop is particularly best for those who lack the discipline to pull the trigger in the heat of battle. But you’re correct, knowing when to get out is the most important aspect here.

It is funny how the money management topic tends to lose some people and you get that glazed-eye look when you start to discuss it, but you’re absolutely right in that several small losses are easily covered by the occasional big win. I think of a good poker player folding, folding, folding and then winning a nice sized pot, so that’s the analogy I’ve used most frequently. I have also seen traders with that 99% win rate who, oddly enough, are no longer trading ;-)

Trade well today and thanks for your comments!

Jeff

]]> by: Trading System Reviews http://www.thestockbandit.net/2008/04/20/stop-loss-discussion/#comment-73220 Wed, 14 May 2008 01:19:37 +0000 http://www.thestockbandit.net/2008/04/20/stop-loss-discussion/#comment-73220 I have found stop losses to be a double edged sword. While they do take you out of a position at a predetermined point they also make you vulnerable to volatility, some of it random, some of it manufactured just to take out your stops! Even if you do not set them too tight to the price initially, it does not take much of a drop in price to make it tight, then you are going to get taken out by even a small downward spike. This is especially true when market conditions are getting more volatile - when it gets volatile you often find the opening and closing prices are not far apart, but the intra-day prices certainly are. Beyond that I totally agree with the sentiment here, you must understand the conditions under which you sell under your system - whether you do it yourself or via stops is down to the system. Also, going back to an earlier point that was made about new traders not knowing how to set stops. When I have spoken to people looking to get into the markets all they want to talk about is 'what should I buy?' It always takes me an age to explain that you can set up a system using a random entry and make money in the long term with good risk management and exits in place so the entry is actually the least important element. You then have to explain there are very profitable systems where only one trade in five is profitable, but the profitable ones are HUGE and others where you can win 99% of the time, but end up with nothing as one of those losers can take everything (just ask Societe General or Barings about that!) The mechanism by which your system works will help you determine your exits, risk management...by this point most people are looking a bit dumbfounded so I usually find I'm talking to myself about the risk management, position sizing and the mental toughness I have found stop losses to be a double edged sword. While they do take you out of a position at a predetermined point they also make you vulnerable to volatility, some of it random, some of it manufactured just to take out your stops! Even if you do not set them too tight to the price initially, it does not take much of a drop in price to make it tight, then you are going to get taken out by even a small downward spike. This is especially true when market conditions are getting more volatile - when it gets volatile you often find the opening and closing prices are not far apart, but the intra-day prices certainly are. Beyond that I totally agree with the sentiment here, you must understand the conditions under which you sell under your system - whether you do it yourself or via stops is down to the system.
Also, going back to an earlier point that was made about new traders not knowing how to set stops. When I have spoken to people looking to get into the markets all they want to talk about is ‘what should I buy?’ It always takes me an age to explain that you can set up a system using a random entry and make money in the long term with good risk management and exits in place so the entry is actually the least important element. You then have to explain there are very profitable systems where only one trade in five is profitable, but the profitable ones are HUGE and others where you can win 99% of the time, but end up with nothing as one of those losers can take everything (just ask Societe General or Barings about that!) The mechanism by which your system works will help you determine your exits, risk management…by this point most people are looking a bit dumbfounded so I usually find I’m talking to myself about the risk management, position sizing and the mental toughness

]]> by: TheStockBandit http://www.thestockbandit.net/2008/04/20/stop-loss-discussion/#comment-67788 Wed, 23 Apr 2008 15:45:04 +0000 http://www.thestockbandit.net/2008/04/20/stop-loss-discussion/#comment-67788 Hey Wilson, Thanks for stopping by and for posting this info on your research. I completely agree that the conditions surrounding one's stop loss should be determined by the strategy being used. As you mentioned, the overall market should have a big influence on how, where and why you're placing your stops. Good stuff and thanks for sharing! Jeff Hey Wilson,

Thanks for stopping by and for posting this info on your research. I completely agree that the conditions surrounding one’s stop loss should be determined by the strategy being used. As you mentioned, the overall market should have a big influence on how, where and why you’re placing your stops.

Good stuff and thanks for sharing!

Jeff

]]> by: Wilson http://www.thestockbandit.net/2008/04/20/stop-loss-discussion/#comment-67481 Tue, 22 Apr 2008 15:42:37 +0000 http://www.thestockbandit.net/2008/04/20/stop-loss-discussion/#comment-67481 Hi Jeff, Our group recently wrote a research paper investigating the impact of the stop-loss on expected return and volatility in various market conditions. In it we identify and discuss the hidden costs as well as the perceived benefits of the stop-loss, profit-taking stops, as well as combinations of the two. Robert Macrae wrote in an article in the AIMA journal a few years ago that looked at hidden costs of the stoploss as well. Rather than increased volatility caused by using leverage to maintain the same exposure, we find that the hidden costs are actually opportunity costs necessarily caused by the impact of the stop loss on the return distribution. Volatility reduction was also found at the position-level. Based on our findings, stop-loss use must be conditional on the type of strategy used as well as the overall market condition. For example, in a sustained bull market, having a -10% stop-loss actually reduces your probability of having a positive 5% return! In general I think for the average (passive) investor it is probably a good idea to have stops out, since they do reduce volatility, but if one is seeking to maximize returns then understanding the mechanics of the stop-loss is essential in incorporating it into an active trading strategy. Abstract: In this paper, we present general implications of the impact of stop-losses to future returns. The use of stop-losses change return distributions, but not in the way that one would typically expect. We find that while stop-losses can reduce position volatility, hidden costs offset perceived benefits in terms of altering future returns. Use of both stop-losses and profit-taking stops separately or in conjunction offer no statistically significant difference in expected return but have a meaningful impact in returns with drift, as the expected return converges to that of the underlying. Blog post: http://advanceyourfinance.blogspot.com/2008/03/re-examining-hidden-costs-of-stoploss.html Macrae's original article: http://www.aima.org/uploads/Arcus66.pdf The paper: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1123362 I hope some of your readers will find this of value. -Wilson Hi Jeff,

Our group recently wrote a research paper investigating the impact of the stop-loss on expected return and volatility in various market conditions. In it we identify and discuss the hidden costs as well as the perceived benefits of the stop-loss, profit-taking stops, as well as combinations of the two. Robert Macrae wrote in an article in the AIMA journal a few years ago that looked at hidden costs of the stoploss as well. Rather than increased volatility caused by using leverage to maintain the same exposure, we find that the hidden costs are actually opportunity costs necessarily caused by the impact of the stop loss on the return distribution. Volatility reduction was also found at the position-level.

Based on our findings, stop-loss use must be conditional on the type of strategy used as well as the overall market condition. For example, in a sustained bull market, having a -10% stop-loss actually reduces your probability of having a positive 5% return! In general I think for the average (passive) investor it is probably a good idea to have stops out, since they do reduce volatility, but if one is seeking to maximize returns then understanding the mechanics of the stop-loss is essential in incorporating it into an active trading strategy.

Abstract:
In this paper, we present general implications of the impact of stop-losses to future returns. The use of stop-losses change return distributions, but not in the way that one would typically expect. We find that while stop-losses can reduce position volatility, hidden costs offset perceived benefits in terms of altering future returns. Use of both stop-losses and profit-taking stops separately or in conjunction offer no statistically significant difference in expected return but have a meaningful impact in returns with drift, as the expected return converges to that of the underlying.

Blog post:
http://advanceyourfinance.blogspot.com/2008/03/re-examining-hidden-costs-of-stoploss.html
Macrae’s original article:
http://www.aima.org/uploads/Arcus66.pdf
The paper:
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1123362

I hope some of your readers will find this of value.

-Wilson

]]> by: TheStockBandit http://www.thestockbandit.net/2008/04/20/stop-loss-discussion/#comment-67296 Mon, 21 Apr 2008 18:10:27 +0000 http://www.thestockbandit.net/2008/04/20/stop-loss-discussion/#comment-67296 Hey John, Good to see you here and thanks for the comment. I think you're right in that many new traders tend to put stops too tight, but upon further review of my phrasing compared to yours ("arbitrary" vs. "loose"), to be honest, neither one offers anything specific. Stated otherwise, a new trader does not know what a "loose" stop is. We could probably agree that selecting an arbitrary level down lower on the daily chart would be better than having no stop at all. I probably should have phrased it that way. Hope this clarifies! Jeff Hey John,

Good to see you here and thanks for the comment. I think you’re right in that many new traders tend to put stops too tight, but upon further review of my phrasing compared to yours (”arbitrary” vs. “loose”), to be honest, neither one offers anything specific. Stated otherwise, a new trader does not know what a “loose” stop is.

We could probably agree that selecting an arbitrary level down lower on the daily chart would be better than having no stop at all. I probably should have phrased it that way.

Hope this clarifies!

Jeff

]]> by: John Forman http://www.thestockbandit.net/2008/04/20/stop-loss-discussion/#comment-67295 Mon, 21 Apr 2008 17:42:44 +0000 http://www.thestockbandit.net/2008/04/20/stop-loss-discussion/#comment-67295 While I generally understand the point you're making with "...choosing an arbitrary price to set your stop is better than not having one at all" it makes me a wee bit nervous being included in a discussion for new traders. If you included the word "loose" I'd feel better because one of the most frequent causes of loss among new traders is setting their stops much too close to the market. They think that reduces their risk when in fact it increases it because they end up taking that loss more frequently. While I generally understand the point you’re making with “…choosing an arbitrary price to set your stop is better than not having one at all” it makes me a wee bit nervous being included in a discussion for new traders. If you included the word “loose” I’d feel better because one of the most frequent causes of loss among new traders is setting their stops much too close to the market. They think that reduces their risk when in fact it increases it because they end up taking that loss more frequently.

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