This article discusses the pros and cons of using stop loss and examines the best stop loss strategy.
The use of stop-loss can be very effective in portfolio management as a risk reduction tool.
I will be a basic but effective Stop-loss strategy that everyone can use in their portfolio.
A stop loss is an active order from an investor who holds a position in a stock.
This job is only triggered as long as it is active as soon as the security price falls below the stop-loss limit set by the investor.
If this price is breached at any time, the order is executed and the investor sells his position at the current market price.
Therefore, stop further losses in the position.
The greatest advantage of the stop-loss order for an investor is that Limit drawdowns on a trade.
The unique versatility of a stop allows an investor to define an amount of risk to assign to a trade.
You can also customize and change this stop as your vision develops.
In contrast to a put option, where the investor has to pay a premium for protection, stop-loss options can be freely placed, monitored and changed.
While a stop-loss order provides a way Mitigate riskIt only provides protection against intraday movements of a security, not overnight jumps.
For example, imagine that Apple is trading at $ 120.
An investor decides they don’t want to lose more than 9% so they put a stop loss at $ 110.
Apple has revenue after hours and it turns out the iPhone sales were a fool.
The stock falls dramatically, opening at $ 100.
In this case, the stop will be executed when the market opens at 100 USD and the investor would have lost twice the stop-loss price.
Looks like the next time they shop, they’ll buy a clamshell phone instead.
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Liquidity events such as flash crashes represent an additional risk to the stop loss.
These can cause the price of a security to fall rapidly, often within minutes, for no apparent reason.
One of the largest flash crashes on the market occurred in May 2010.
While there were some macro events that warranted a small drop in stock prices, an 8% drop made absolutely no sense.
An investor may not have had any intention to sell due to the peculiarities of the decline, but could have exited the bottom (red circle), only to largely recover the shares minutes later.
Now these two disadvantages can easily be remedied with a put option.
The problem is that the premium paid for a put option can often piss off an entire strategy.
After all, insurance is not free.
So how can we implement a simple stop-loss strategy in our portfolio that minimizes these problems?
This strategy seeks to capitalize on the market anomaly of momentum.
This anomaly states that stocks trend more often than they do a return to the mean.
In addition, we limit drawdowns by placing stop-loss and thus increase our risk-return or Sharpe ratio.
The strategy is simple. Buy SPY and put a stop loss on the 200-day moving average (blue line in the chart below). This stop loss could then be adjusted regularly, for example once a week, if the moving average changes.
As soon as the index crosses the 200-day moving average, trading will stop.
At this point, a new stop buy order will be placed on the same blue line to re-enter trading as soon as the index overtakes the moving average again.
So what would it look like? Let’s have a look!
Here we have a backtest from 2006. We see that by implementing this strategy we would have avoided most of the drawdowns in the 2008 financial crisis, the 2018 correction and the 2020 Covid pandemic.
This performance is even better with risk-adjusted returns.
Because of the smaller drawdowns, an investor could apply leverage and easily outperform the index.
Or, alternatively, have less variance while getting equity like returns.
That looks too good to be true. Then why don’t everyone do it?
The answer is many do. In fact, trend following and other volatility targeting strategies are favorites among active managers.
So while many private investors are on buy the dip (which works fine until it goes out) the truth is, at least throughout history, the trending and selling of the dip is much better.
Even so, the strategy isn’t a free lunch.
For example, while the yellow arrows might seem insignificant, they would be periods when you would be whipped around.
Re-entering positions only to be stopped out weeks later, and then doing it again while also piling losses.
If the market has volatility in both directions over the long term, but the index stays in the range, this strategy will lag behind simple buy-and-hold investments.
The thesis and potential alpha of this strategy are based on belief in momentum in the markets as opposed to mean reversion.
The risk of flash crashes
On the risks of Lightning crashes and price jumps.
For this reason, I also choose the S&P 500 for this strategy and not individual stocks.
Individual stocks have a far greater risk of spikes and jumps, even with conservative stocks.
For example, while the same 2010 Flash crash was down 8%, Proctor and Gamble lost over 20%! Worse still was the erroneous stock price that nearly blew up Mad Money’s Jim Cramer on live TV.
Remember that Proctor and Gamble is a very liquid stock. Let’s imagine a Chinese ADR with small market capitalization with limited liquidity. It may not be nice.
This is just one example of a simple stop-loss strategy.
There are many others that can be effective.
For example, if you thought there was a price floor at a certain level, you could place a stop loss below it. If this lower price limit holds and your thesis holds, you will stay in this position.
Conversely, if you are wrong, you can leave the position quickly.
This mechanical ability of stop losses is a hidden advantage as it can allow investors to stick to their strategy and avoid worthless companies.
Shares of Enron anyone?
Stop losses provide a unique way to limit the loss of a position while eliminating the need for an investor to constantly monitor positions.
They also offer the versatility to be adjusted, changed, and modified to suit a person’s risk constraints and point of view.
All of this can be done for free, unlike put options.
While there are some drawbacks and risks associated with using stop-loss, these can be partially mitigated by focusing on very liquid products with less risk of jumping and manipulation.
Disclaimer: The information above is for For educational purposes only and should not be treated as investment advice. The strategy presented would not be suitable for investors who are unfamiliar with exchange-traded options. All readers interested in this strategy should do their own research and seek advice from a licensed financial advisor.