The case against stop losses

The common wisdom is that one should never enter a trade without having a stop in place, whether it’s a hard stop or a mental one. There are those, however, who find stops a conceptually bad idea. They would undoubtedly side with enlisted members of the U.S. military where a stop-loss order extends the term of their service (and presumably their pain).

First, a simple one-liner: “Stops are basically breakouts in reverse, and by their nature all breakouts give up a major portion of any potential trading profit.” José Silva, MetaStock Tools.

Second, from an article “The Hidden Cost of the Stoploss” by Robert Macrae, which appeared in the AIMA Journal (April 2005). Macrae admits that stop losses make sense for trend traders: “for positively-autocorrelated (or trending) series, . . . when the stop is hit your expectation is that further losses would have followed.” But, in one of the more often-heard critiques, he contends that on mean-reverting trades stop losses “systematically take you out of your best positions.” (Macrae’s paper goes well beyond this basic point; readers interested in his argument should also look at a follow-up paper by Detko, Ma, and Morita, “Re-examining the Hidden Costs of the Stop-Loss.” )

The debate about the efficacy of stop losses is important. Perhaps sometime down the road I’ll go into this debate in more detail, but for now I’m just throwing out a couple of ideas as food for thought. In the meantime don’t abandon your stops based on this brief post. Ideas come cheap, real losses are expensive.