The last time I did helped a friend develop an investment strategy he was under the impression that as long as he put stop losses in place that he couldn’t lose more than that amount of money under any circumstances. That sounds all fine and well since that’s what stop losses seem to be for, and in some cases that’s the truth. But it’s not always true. There are tons of different market factors that come into play when a system attempts to execute a stop loss. Let’s talk about a few of these situations.
To run these studies we need a base. Let’s go with the Equities Lab featured Screen “Good to Great”
Prior to adding any stop loss constraints our strategy returns an average of 21% annually with a Sharpe ratio of 0.24. On top of that, the best position taken on during this time was KWR returning 158% and the worst position was UAL returning –81%.
The standard thought process and argument for stop losses would be, well, if I lock out the low end I can keep myself from losing exuberant amounts of money on any one position and almost eliminate the downside risk. Sadly, this standard thought process doesn’t always pan out. Let’s add a 10% stop loss to the strategy.
All things the same, the strategy where the stop loss is implemented returns just under 12% annually. Still not a bad return. I’ll take 12% at a low standard deviation any day of the week. However, it does almost cut our performance in half.
Our best position changed to TNC returning us 152% – so we are securing a lot of the upside, but if you look our worst position is just under –40%. How could this happen when we set a stop loss of 10%? For that we will need to jump over and take a look at our positions.
Here is the stock chart of our worst position, interesting that they delisted only a few short years after we invested in them.
Anyway, we bought into IRIC on September 2, 1998, and got out of it on October 8, 1998. Not a long time to be in a position, but it looks like this company was falling from the start. Surprisingly, this position actually made us money for a span of about a month, but on October 7th, the stock suddenly dropped after hours by about 40%, and sadly, a lot of times this is the time when big movements in a company’s share price will be. On top of that, we may have not even been able to exit the position as it could have been falling fast enough that your stop loss wasn’t able to get an order in on time. So you’ll end up closing out of the position the next day at whatever price point you can.
Stop losses are great at times, and can eliminate some of your more volatile positions, or nicely close out of positions that are slowly declining in the event that you are a hands off investor. But if you are relying on stop losses to eliminate all of the downside in your investments , especially if you are participating in high risk trading, then you are going to be in for a surprise when your positions don’t close out properly and your stuck selling your position at a much lower level.