Are stop losses hurting your performance?
There are a number of topics that come up on a regular basis on the trading blogospheres. The most important and the most frequently discussed is “how the markets are rigged.” Anyone who has been in this business for any length of time can tell you with 100% certainty the markets are rigged.
Plain and simple, the markets, specifically the exchanges, are totally geared towards screwing you, the retail investor.
I used to always put in stop loss orders. It was just part of the trade. I would enter a trade and then immediately put in a stop loss order. It was second nature, I didn’t even have to think about it. Then I noticed something. I was stopped out then the stock would reverse and head the other way. What the heck was happening?
But before I get to the research, I would like to tell you what Bruce Robinson, (the contractor I use for my algorithm development and a person who has helped me more than anyone develop QiT’s awesome algorithms) said when I posed the question about stop losses to him.
“Early on, I did quite a bit of testing with stop-loss orders (and trailing stops as well). My conclusion was that they hurt the results of the vast majority (almost all) trading systems, or resulted in over-fitting of stop parameters. So, I decided not to use them, and not to incorporate the option into systems. I later confirmed this with others. Howard (Bandy), for example, also says that they almost always hurt performance. Please note the above statement is talking about perfectly executed stops where:
- other participants such as brokerages or ECN’s did not have knowledge of stop points
- executed order prices trigger stops
In practice, the steps perform even worse because the above two conditions do not hold true.”
Dirty Little Secret #1. Market Makers Run your Stop Losses
Some market-makers play a game (these days, it will be computer algorithms) called “run the stops.” This game forces a stock low enough to trigger a large cluster of stop-loss orders (usually at round numbers or well-known support and resistance levels). After the stock sells at a popular stop loss price, the stock reverses direction and rallies. Here is how one market maker put it,
we big boys are takin’ out all the suckas that are sittin’ in the corner with their thumbs in their mouth all worried that they trade is gonna get stopped out. Then I come along and, BLAM take those stops out and let the momentum take off as I start collectin’ chedda …..”
That was an actual comment from a market maker. I’m not entirely sure what this dude is saying – I don’t talk his lingo – but suffice to say it is not good for us small investors. Makes you all tingly inside heh?
Dirty Little Secret #2. Don’t Think Liquidity Will Overcome #1.
Often during the middle of the day, you will see stops get run, usually below obvious support levels, only to see the price reverse immediately and begin climbing. This is possible because liquidity dries up during the middle of the day. Meaning that much less volume is needed to move a stock.
This will happen even when a stock trades millions of shares a day, the implication being that the stock is too liquid to manipulate. But what you don’t realize is that the vast majority of volume takes place in the first and last 30 minutes of the trading day. Often 50% or more of the day’s total volume takes place during these periods. That leaves 5.5 hours of relatively light volume, where price can more easily be directed towards pockets of stops. Low volume periods during the day allow easier price manipulation and the ability to “clear out” areas where stops congregate.
Dirty Little Secret #3. Stop Losses can be Triggered Without A Trade.
Let’s say ABC is currently trading at $20.50, and you have a stop market order to sell at $20.00. Price approaches your stop and it gets triggered and you are filled at $20.05. But when you look at your chart, you see that the lowest price got was $20.04. So how was a stop triggered at $20.00? When you put a stop order in you place a market order. Which for lack of a better word, is in a “suspended” state. It is not active until the price hits your stop, or trigger price. Once that is hit, your market order is then live, and acts like any other market order. But what you might not know is that there does NOT actually have to be a trade at your stop price in order to trigger the market order. Only a QUOTE needs to be shown at your stop price in order to trigger your market order. Bet ya didn’t know that heh?
Dirty Little Secret #4. Studies Point to Stop Losses Hurting Strategy Performance.
As well as Bruce Robinson’s observations, Larry Connors and Cesar Alvarez have done hundreds and hundreds of tests looking for the optimum stop loss level. They ran their tests over eight million trades going all the way back to 1995 with just a simple pullback methodology. They, first of all, ran the tests without stops and then they put in stops of 1%, 3%, 5%, 7%, 10%, 25%, and 50%. What they saw all the way through was that no matter what stop they used, it hurt the performance.
What they saw all the way through was that no matter what stop they used, it hurt the performance. It was somewhat eye-opening! No one in the Connors Group expected that even a 50% stop lowered the performance vs having no stop at all, which they thought was crazy. It didn’t matter where the stop was, performance was lower. They saw this over and over again.
The Connors Group hasn’t used stops in their short-term trading with equities and ETFs for years with positive results. It can be done – protection can be done different ways. Careful position sizing (like we do at QiT) is one way for the best protection – it’s a form of insurance. If you are using proper position sizing, no matter what happens a trader should be at a point where “there is no way one position could blow me out here.”
One last point on Connors Group research, it was not done under the conditions of #1, #2 nor #3. And it had been, the results would have even been worse.
They give you a false sense of security and cost you money in the long run.
We know that trading is like playing both “chess not checkers” at the same time but not anymore. Now it is like that 3D chess game they had on the Star Trek hologram, with a little Dungeons and Dragons thrown in for spice.
You can no longer use the old trading idiom of “always use stops” when trading equities or ETFs (this does not hold true for options or futures) for you are no longer playing on a fair playground – as if you ever were. You have to be able to modify the traditional trading rules when it comes to stop placement and trade management. And even more critical is the ability to think on different levels, many moves ahead, and be willing to evolve your methodology for the ever-changing market.
We’re the Plan in “Plan your Trade and Trade your Plan” – TraderJanie
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