Friday, January 23, 2009

Stops Part 1 - When Not To Use Them

One topic I’ve received a good number of questions about lately is Stops. Using a stop on a position is a very popular risk management technique used by traders. My research and experience has led me to believe they are appropriate for some – but not all – types of trades. Today I will discuss when I believe they aren’t appropriate.

In Larry Connors new book, “Short-term Trading Strategies That Work” he dedicates a chapter to stops. It’s entitled, “Stops Hurt”. The chapter discusses how Larry’s research team ran hundreds of tests to try and find optimal stop levels. In doing so they came to the conclusion that for the trades they were looking at, the optimal stop was consistently none at all. In every case they found that instituting stops hurt system performance.

You should keep in mind that Larry Connors trades mean reversion strategies. Much of what I do is mean reversion based also. For instance, the Catapult system which makes up the CBI looks to buy stocks that are undergoing capitulative selling. It enters long positions in stocks or ETFs that are extremely oversold. When I first designed the system in 2005 I went through a massive series of tests to find a way to successfully incorporate stops into the methodology. Like Larry I failed to find a stop technique that would enhance the performance of the system.

I’ve gone through numerous other exercises and found the same thing time and again. 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.

One stop technique for oversold systems that I will sometimes use that in testing hurt performance less than the other techniques I evaluated is this:

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.

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). I wrote a series back in the Spring (when the VIX was a lot lower) on how I sometimes use options for my short-term trading. You can find links to that series below:

Options – part 1
Options – part 2

This is getting a bit lengthy so in a future post I’ll discuss situations when I believe stops are absolutely appropriate.


Anonymous said...

Thanks for the grat post Rob. This is a topic which I have struggled with and came to basically the same objective conclusion that you did.

I would love to see/hear any more posts on this topic

Anonymous said...

I have to respectfully disagree with this post. Specific stop point can be determined by different measures of current market volatility. I actually touched on this subject this morning in relation to another position size.

One does not need to have a high or low in mind when placing a stop, just determine the market volatility and that should give you a good idea of where to place a stop.

I use this technique in one of my oversold/overbought systems. Without stops I have found that all my oversold/overbought stuff would eventually get wiped out.

This is what I have noticed from my studies.

Anonymous said...

I got burned several times, quite painfully on BSC and UNG last year. One catastrophic loss is all you need to finish the game. Imagine what will happen if this position turns out to be temporarily correlated to another one or more, even though it normally does not exhibit such correlation...
No stops means VERY SMALL position size and a tiny expected profit per trade (assume<0.1% of your capital) so one's system must allow for hundreds of trades per year in order to make sense.

Anonymous said...

Stops are a complicated topic. In mean-reversion systems, if prices move against you, then your system will tell you to increase your position size. Which works most of the time, but not when you are completely wrong (then it will lead to unmanageable losses). In a trend-following system, you should have a better exit strategy than stops. In both cases, if stops are improving your unleveraged profits, it means you didn't design your system properly. But in both cases you can get lower volatility with stops (which allows for more leverage or lower drawdowns). So stops will only actually improve profits if you have a bad system or if you use them to increase your position sizes.


Jeff Pietsch CFA said...

First, terrific post. My comment is that I believe most active traders discover this over time. The reason they don't work for them is because they already have a dynamic exit strategy as part of their trading methodology. For "buy and hold" investors, placing a stop may be their only planned method of exit, and thus enhances portfolio returns. Make sense? Rubbish? Have a good one, Jeff

Anonymous said...

Doesn't Connor's have a rule that he never buys oversold on a stock below its 200-day MA? So what happens if it falls below 200-day MA when you are in the trade?

Unknown said...

I was curious to know if your trade became extremely oversold like your example of a security dropping below $20.00 to $18.00 what the results would be to buy more of that security, future, at those extreme oversold conditions? This strategy has worked well for me. How often do your extremely oversold conditions continue to drop without a bounce, thus causing a possible wipe out?

Jeff said...

Rob, I think a distinction should be made for stops used in common stock/equities vs. indices and ETFs.

I am currently testing another mean-reversion system that trades on common stock. When the market conditions are ripe, this system may signal 1-6 entries a day, for several days at a time. The system will not take every signal but will instead run a final filter to decide the best of the candidates.

A percentage stop is used, which outperformed ATR stops during testing.

And here are my points:

1. The system creates positive expectancy. As you know, opportunity x expectancy = profits. Any positive expectancy system should theoretically hit an equilibrium where the reduced win% is balanced by the increased number of opportunites. The system will need to trade often to provide enough opportunity to overtake the increase in losing trades.

And that is why I mentioned the need for indexes vs. common stock trading.

The indices may not provide enough opportunity to overtake the losses incurred more frequently. Furthermore, while common stocks will sometimes go to zero, indices are less likely to.

Therefore, I can understand the argument that considers it a mistake to use stops on a MR strategy applied to the indexes.

DowCow said...

What? This is almost heresy to me. I don't trade mean reversal systems. So, given the tenets in your proposition, it seems reasonable - for that system. I know of a trader who used a successful mean-reversion system until the crash of 2008..... He is down 75%. It may revert back to the mean, but with much wider swings in equity.

heywally said...

This piece on stops rings 'true' for me, based on my experience but only if:

- you are not putting on too large of a position initially

- you are coming from a large cash position

- you are trading an index and not a specific stock. (this is important because a single catastrophic event in an individual name can wipe out tons of profits)

Of course, the selling in the past few months has redefined capitulative selling so that is tricky.

DowCow said...

An idea just came to me after my post today (where I thought not using stop losses is 'heresy' :) ). The use of options without stops is a viable idea. Just choose an option premium (assuming a debit position) that you are comfortable with, and then take zero as the stop loss. Say an option of $2.00 ($200 debit), would have a stop loss of $200, if it goes to zero. It can be left to expire worthless.

Rob Hanna said...

Thanks for all the thoughtful comments. I'll address much of what is discussed here in my next few posts on the subject.