Rethinking Stop Losses

• Posted by Robert Sinn
• on March 26th, 2012

The use of stop-losses is one of the most basic and sacred rules of trading. To trade without using stop losses is virtually akin to skydiving without a parachute – for traders, placing stop losses is an involuntary reflex much like breathing. However, a recent study (which I am a bit late in reading) casts a considerable degree of doubt on the value of stop losses. “Re-examining the Hidden Costs of Stop Losses” convincingly demonstrates that stop-losses have a high degree of “hidden costs and perceived benefits”. The authors use a simple yet elegant chart to highlight this concept of perceived benefit and hidden costs:

The diagram on the left is the perceived benefit of using stop-losses while the chart on the right is the authors’ finding as to the actual hidden costs of stop-losses. Stop-losses essentially lead to a large number of small losses which according to the authors tends to outweigh the benefit of the reduced number of larger losses over time. They are sure to add in slippage and transaction costs into their calculations which of course makes the use of stop-losses an even costlier strategy.

The authors also point out that in market conditions which display “positive drift” (uptrending) stop-losses (they only seem to address long positions using sell stops) are a net negative on investment returns, whereas, stop-losses are a net benefit in markets that display “negative drift” (downtrending). Of course, this is all quite logical and makes perfect sense from the perspective of an investor with a longer term time frame (more than one year) using a diversified portfolio strategy. However, the authors don’t address the concept of shorter term trading or traders who use leverage – this research report repeatedly uses the words “investors” and “investing”.

I agree with the general premise of the work in that for long term investors with well diversified unlevered portfolios, the use of stop losses and trailing stop losses does not make much sense. One of the primary goals of long term investing is to be able to weather short term market volatility and noise in order to catch the big secular moves that make all the difference in long term returns.

Meanwhile, I believe that this report is worthwhile food for thought for traders in as much as it highlights the huge challenges of market timing and overcoming noise while managing risk. This research does not apply to short term traders due to the fact that most traders:

• Often sell short which can lead to unlimited losses without the use of stops
• Often use leverage
• Have a limited time frame and return percentage for profit targets which logically leads to a limited time frame and loss percentage for losses

The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.