When Does It Really Pay To Use Stop Losses?

18th Apr '17 by Ben Hobson

25 comments 16751 reads

The subject of Stop Losses provokes heated discussion here on Stockopedia. Opinions are divided on how, why, when, where and if you should set a pre-defined exit price on a trade. Some investors won’t use stop losses, but others can’t live without them.

One of the biggest questions about stop losses is why they should even be used in the first place. Those in favour point to the benefits of lower volatility in a portfolio and protection from sudden single-stock disasters. For that reason, they’re often promoted by traders like Robbie Burns and Mark Minervini.

But the counter argument is that a regular buy-and-hold strategy (without stops) will even itself out over time. Without a stop, you won’t be at risk of being shaken out of a position. You won’t be left wondering what to do if you’re stopped out. You won’t be hit by extra trading costs. And you won’t be at risk of missing a recovery.

The arguments on both sides are persuasive. So in the coming weeks, we’re going to be looking a little closer at stop losses and exploring some of the science and behaviour behind them.

To start, I’m going to look at research into whether stop loss strategies are superior to buying-and-holding. Spoiler alert: Don’t expect all the answers. I discovered that even one of the leading authorities on the subject believes that there are always trade-offs between the two!

Why there are two sides to stop losses

To begin with, it’s worth thinking about the nature of stop losses and how they’re used. Arguably, many see them as just a risk management tool for cutting losses if prices tumble. That’s perfectly reasonable but there’s a problem here. The decision to sell often isn’t balanced by a pre-planned strategy for buying back in again. Ignoring this second part means not having a plan for staying invested in equities as much as possible.

The question of when to sell and when to buy back was the focus of a study by Joachim Klement, who’s currently head of thematic research at the investment bank Credit Suisse. In 2013 he endeavoured to figure out when stop losses worked best using global market data spanning 1970 to 2013. He started with the following set of possible tactics:

1. Fast out / fast in (three months / three months): In other words, sell the asset if the…

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Carey Blunt

18th Apr '17

Good article but I struggled to grasp what it practically meant to be slow out / fast in etc. Any chance of some worked examples to show the difference or an example graph?

Nick Ray

I have a few problems with this study. Firstly it is not really investigating stop-losses, but a method which makes a 3-month (or 12-month) decision whether to retain an asset based on its return in the period.

The assets are mostly complete 'markets' so they already contain no idiosyncratic risk, and so this paper is entirely concerned with mitigating market risk. In two cases he could not show that the asset class was not in fact a "random walk" (aka Geometric Brownian Motion (GBM)) for which it is trivially easy to prove that stop-losses (or any other price-triggered entry/exit) cannot work.

But the biggest problem is that in the various contour maps presented to show how each asset responds to different thresholds, the contour maps are not the same shape (qualitatively) for every asset and in some cases exhibit strong hints of simply reflecting something specific happening in the data set (because they have spikes and other strange preferences for particular combinations of the parameters.)

So for me it is a data fishing expedition that hasn't really found anything. That would not be too surprising. Can you really increase the risk-adjusted returns for a market index simply by entering/exiting on a momentum signal (similar to stop-losses)? It would be very surprising if that were true. I also fear that trying to read anything from this across to individual stocks is doomed to failure.

GrindertraderUK

19th Apr '17

As many know I am a fan of using stop losses for all my trading / investing including my non leveraged accounts. I don't wish to repeat what I have written in the past, however I have decided to post this snapshot from one of my leveraged account. The purpose here is to demonstrate that by using stops, exiting quickly anything that goes in the wrong direction etc then I never have the bad feeling of staring into a sea of red.

This is also the same strategy I use for my ISA accounts, and helps me avoid the over confidence trap.

edited to black out figures since the purpose is to demonstrate profit/loss %

seadoc

Ben,

The key to making a profit is running winners and selling losers so automatic stop losses should in theory preserve your wealth. A tactic that must surely work but clearly did not, so 20 yrs ago I set up personal (that is, not automatic) stop losses on every share in portfolio that is set up spread sheets for each share, looking at historic volatility and identifying % change for stop loss on that share. That does not work either. At the time Warren Buffet had a single copy of WSJ delivered to Omaha and on the basis of that, yes: yesterday's closing prices, became second wealthiest man in America.

So.... do not sell just because you have made a profit, do not hold onto losers and invest only in small companies which are below radar of clever computers because the apparent spread is too wide and the potential profit is measured in hundreds rather than millions. Oh and read Paul/Graham daily and most recently I am doing better by concentrating on companies whose business I can not just understand (like Warren advises) but also in areas of which I have previous experience.

If I am still investing in 10 yrs I will let you know how that goes.

And finally: have a think about what Gervais tells us in The Retreat of Globalisation. The bottom line of his book to me is that the next three years will bear no relation to the observed, practiced and profitable investing principles of last thirty years. I have sold out of a lot and become very stock/sector/concept specific.

Good luck,

Seadoc

Investor & Trader

Hi Grindtrader,

What leverage do you use on your account? I currently use 130%

My maximum per stock is a 5% holding

Just wondering how this compares to you..

Thanks

Metatron

20th Apr '17

Generally use a 25% stop loss except with occasional seasonal trades such look at what goes up January and if buy a stock sell in May .
However when one gets elections such as now in the UK I look to sell until the election is over
Made the mistake of not doing that with Brexit and the airline stock and housebuilder stock I held got slaughtered

Redrichmond

31st May '17

One thing I noticed recently was I stopped out by Stop loss hunting. It was £200K with a stop of 730 and actually sold for 718.. I came back in (via telephone at 790) and now its 858.. So made up my loss and some.. Proper solid share but some tree shaking going on. Now unless you can use Trailing Stop losses I don't see the point. H&L don't offer this. But if it was trailing it would automatically move up and done 10% (a huge dip for this share is 3% so its pretty solid and rates very high on stocko)..Lots of reading and the depending on the share 7-15% with the spread factored in. Mark miniveras book is very good and has a whole chapter on this

cafcash49

16th Jun '17

Coming late to this discussion. After many changes of view about stop losses I have finally found a system that works for me. I set a stop alert on Stockopedia which means I get an alert by e Mail when a stop is reached. My default view is to then sell but first I review everything and sometimes make the decision to hang on if I think it is a tree shake or just a minor pull back. I also review the alerts monthly to move the stop up if the share is doing well. Hope this helps. Charles

ricky65

I think using a price alert system for stop losses is all well and good but the problem is having the discipline to sell when your stop is hit. It's so easy to rationalize the drop and make excuses not to sell.I'd be kidding myself if I thought I would sell every time my stop loss is hit manually. For that reason I use automated stop losses with my broker. I like to do a weekly stop loss review and trail the stops. Another advantage of automated stop is the issue of not being available to sell at the moment the stop is hit (most of us are at work during trading hours). For me, successful investing is about having the discipline to stick to a winning rules based approach. Yes, occasionally you will get shaken out but it's better overall in my opinion.

Ricky 65, you are absolutely right about having the discipline to sell but my default is to sell on warning but check it out before I sell because there are so many examples where I have sold on auto SL only to see the share recover quickly and continue to rise. It works for me and won't suit everyone. I am fortunate enough to be retired (or not) so I can monitor more closely. Investing is my job now!! Good luck with your investments and thanks for responding, it is always good to know someone is reading the posts. Charles

Ricky 65, just read a few of your recent posts, I too like Minervini and now follow the idea that there is no point in buying in phase 1, let phase 2 establish even if it means missing a few percent and get out in phase 3 before phase 4 sets in. Sounds easy but as always slightly harder to achieve. But no more buying jam tomorrow they have to be rising now. Good to talk, must mow the lawn now. Charles

JamesrWilson1989

The Caf,

Can certainly understand your approach but when stocks hit a stop loss doesnt mean you need to be right 100% of the time, only that the automated sell saves you more money than you lose in the longer term. You will of course be stopped out of potential winning situations but if its right 51% of the time then its worth having.

Hi James, I set my SL Alerts at 10% drop, so there is often no urgency but it alerts me that the trade is going against me so I can then make a decision to sell or hold. As I say it works for me but will not work for everyone. Good job were all a bit different otherwise share dealing wouldn't really work if we all did the same. Have a good w/e, now I really must go and mow the lawn! KR Charles

Rusty2

Not if you are taken out and then the shares go up over 100%, so not only have you lost 10% but you have lost 100% profit so that is over 110%. It did not save me money it cost me money that's why I don't use auto stop losses anymore.

Hi Herbie,

Yes it's not for everyone so glad to hear opposite views.

I can only comment on my own investments and say that since implementing stop losses it has improved the performance of my portfolio considerably. Like all the content we see on this website, it's not trying to preach to anyone but give people ideas which they can work on themselves.

Yes they work for some people but I prefer to monitor my shares and then decide rather than an auto sell. But you need time and discipline. My biggest losses are from selling out too early. I often find a price fall is a buying opportunity, I have picked up quite a few shares on falls, such as JD Sports Fashion (LON:JD.), Tristel (LON:TSTL), Bioventix (LON:BVXP), Staffline (LON:STAF), but it depends why the price has fallen. Conversely I often take profits if the share price shoots up for no apparent reason.

If you got stopped out do you buy the shares back ever?

I would yes

For me - stop losses aren't anything personal so I dont have any more emotion buying a stock I've sold out from or one that is totally new from my radar.

Since adopting a 100% 'automated' profile from Stockopedia based on certain criteria, including momentum, I have found my returns have improved so much. The problem I faced when I was first investing was selling my winners to soon and seeing my losers to late and no matter how much I told myself this was the wrong thing to do, I found my emotion got the better for me.

I set a 20% stop loss when I purchase a share and when that hits, it will no longer qualify for my criteria due to the share lacking momentum. If that same stock appeared on my screen 1/3/6 months down the line, even at a higher price, I would get back involved.

Thanks, 20% is quite low, I'm typically out of a share well before that if things are going the wrong way. It also depends on the shares some are volatile, take Beximco Pharmaceuticals (LON:BXP) which I hold it was down 11% yesterday but up 13% today, some would have been taken out yesterday. I think a lot is getting to know a company, for me it's different new v old shares.

18th Jun '17

Hi Charles. One thing that comes to mind if you were getting stopped out too often on shares that recover - perhaps your stops were too tight? Personally, I give small caps more room than say a FTSE 250 share because they're more volatile.

I am a fan of Minervini, quite simply because his strategy is the most successful I've yet come across. I also don't buy in Stage 1. Ideally, I like to buy in the Stage 1 to Stage 2 transition where a stock meets his Trend Template criteria and breaks out from a VCP base. The problem buying is Stage 1 is that the stock could trade sideways or down for months or years which is an opportunity cost. Thus giving up a few % for confirmation is fine.

I wish you luck with your investments too.

Kind regards

Ricky

ACounsell

25th Jul '17

Since investing in SmallCap stocks on a regular basis in 2014 I have tried to use manual stop loss set at c. 20-25% given the inherent volatility of small cap stocks. This has been frustratingly unsuccessful given that many stocks haven fallen precipitously before I could hit the sell button. Over a period of 2-3 years 11 stocks (admittedly a small sample) sold on hitting a stop loss which sometimes massively exceeded the target 25% due to dramatic falls during a single trading session (Revolution Bars (LON:RBG), Plus500 (LON:PLUS) to name but two) resulted in notional losses of £4.5K due to 8 out of the 11 stocks 'bouncing' back to levels significantly higher than the sold price (which was often closer to 35-50% down from cost or 52 week high whichever was higher than the 20-25% I would have liked to operate). Admittedly if an automated stop loss of 20% had been in place and it was possible to execute a sale at that price (not always the case in with a dramatic fall) then the notional loss would have been reduced to £1.2K which I guess is a lot better but still not a great advert for a strict stop loss policy!

When does it really pay to use stop losses?

Why there are two sides to stop losses

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Ben Hobson

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