The Efficacy of using Stop Losses: 11th May 2014

The Efficacy of using Stop Losses: 11th May 2014

Following a discussion on the ADVFN FX forum thread I thought I’d reproduce my post here so as to keep it for future reference. Please note that some of the statements herein are taken from a research paper written by William K.N. Chan, former Head of FX Strategy in HSBC Asset Management.

I have a consistent swing trade win rate of around 75% and a day trade win rate of between 75% to 90% of all day trades taken over a typical Month yet the value of my account does not increase proportionally with that win rate because a fair percentage of my losing trades incur a loss greater than the gains made on an average winning trade.

This led to the question, is this due to poor stop loss placement or simply not running winning trades to their full potential?

So to study stop losses in a little detail we need to establish why we have them:

1) To control the risk of ruin which refers to the cases whereby a major loss from one/two position(s) seriously undermines the capital base so that trading activities have to stop.

2) To enhance returns by through discipline by forcing traders to cut losing positions and ride winning ones. It is expected to limit losses to small amounts, without constraining profit potential, resulting in an enhancement of return over time.

However, the truth, according to K.N Chan’s study is this:

“Stop-loss mechanisms undermine the performance of profitable trading strategies and improve that of the unprofitable ones.”

This essentially means a stop loss will reduce the profits of  a profitable trading strategy. Stop losses will however reduce the losses of an unprofitable trading strategy.

If 75% to 90% of my day trades are consistently closed with a profit the implication would be my overall strategy, or system, is potentially a profitable one who’s potential is being limited either through stop loss positioning or my chosen exit prices.

Here’s a real example of a good trading strategy that used a stop loss incorrectly, and a poorly considered reaction trade that used a stop loss correctly. Note the prevailing trend was up and following a healthy 2 day pull-back I attempted to enter into the bullish trend, but it all went disastrously wrong:

Stop losses.

The Real Benefit of a stop loss is a psychological one that helps the trader avoid last minute decisions which tend to be less well-thought out or irrational. When forced to make a last minute decision under pressure, you are more likely to suffer from the “fear of regret” syndrome. That is to say, having lost money in a position, most would hesitate to cut the position, fearing that the market price could reverse course, causing regret. A discipline in stop-loss reduces the need to make last minute decisions and thus reduces the undesirable impact of “fear of regret”.

Consistent value added from stop-losses should not lead to complacency. Instead, it should be taken as a warning signal that the trading strategy may contain a particular weakness which is responsible for the consistent profitability of the stop-losses. To the extent that is possible, such underlying weakness in your system should be overhauled directly rather than controlled by a stop-loss.

One suggestion on the forum was to find a stop loss level first and then design a trade around it, only taking the position if the R:R falls within your risk limits.

K.N Chan explains the disadvantages of a stop loss:

1) Dilemma in re-entry. This is especially problematic for trend-followers. Stop-loss could be triggered by short term volatility, despite an unchanged underlying trend. Once stopped out, one has to face the dilemma of whether to re-enter the trade. If one should decide not to re-enter the trade despite an unchanged trading signal from the investment process, the integrity of the investment process could be undermined. If, however, one should opt to re-enter the trade, the original objective of applying stop-loss would be defeated.

2) Ineffective risk control Many investors have “risk-control” in mind when adopting the stop-loss discipline. Unfortunately, stop-loss by itself is not an effective tool in risk-control. Although stop-loss reduces the risk of a single large loss, it can generate a series of small losses, which in total can exceed the single loss. Our test results, for instance, suggest that the stop-loss mechanisms tested influenced primarily the pattern rather than the probability of loss. To most investors, it is the latter which matters. Without understanding this, an application of stop-loss could generate a false sense of security, or even result in a sub-optimal risk control. In fact, if one’s prime objective is to control the “probability” of loss, then, instead of seeking to control “LOSS,” which is an ex post parameter, one should seek to control “RISK,” i.e. expected tracking error, which is an ex ante parameter.

My conclusion based around my own day trading system shows that if I took less trades but held onto each trade longer the percentage of my winning trades would be reduced, but the profits per winning trade would increase, essentially an increased level of profit for a reduction in workload. At the same time however, the number of overall losses would increase. I’m yet to establish how that would ultimately affect overall profits though it would seem logical to suggest they’d increase.

Through identifying past day trades where the position was stopped out it becomes apparent that were I to use a stop loss based on the closing level of a candle rather than its ultimate high or low, I’d suffer far less stop-outs. There’s no automated system that can facilitate this, but I think you can all relate to situations where the trend you were trading remained completely intact after you were stopped out on a spike of some kind whilst the candle that stopped you out ultimately closed inside your stop loss level.

The issues I refer to throughout this post are based around my day trading strategy but to some extent they also apply to my swing trading strategy where poor stop placement (or closing wins too early) has severely impacted the potential profit the trade could have ultimately delivered.

The fact that I use disproportionately wider stops on swing trades compared to day trades probably in itself demonstrates poor stop loss placement on day trades which is probably due to inadequate R:R from the outset, i.e a solution being to re-assess Risk/Reward as a way to increase profits on winning trades which should out-weigh the losses incurred on losing trades.

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