Monday, February 22, 2010

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.


  1. Brenda,

    Dr. Steenbarger also recently had an interesting article on this topic; he in turn refers to a paper by Henry Carstens, of Vertical Solutions.

    My view is that - once you have acquired some experience - what works best for intraday trading is to have a relatively tight mental stop based on market conditions plus a wider hard stop for those "deer in the headlights" moments that a friend of a friend sometimes has.

    Looking forward to your ideas on the matter.

    Best trading,


  2. Jorge,

    Thanks for calling my attention to this article and the Carstens link; somehow I missed it.


  3. Thanks, Brenda.

    From experience, I'd say that stops should only be thought of as a safety net in case the real exits fail. What, no exit strategy? :(

    To use an analogy, drivers generally steer their car out of potential trouble, and only occasionally apply the brakes in hazardous situations. However, depending on stops to take us out of a bad trade when most of the damage has been done, is akin to depending on seatbelts or airbags to come to a safe stop after an accident.

    We should aim to steer our way out of bad trades, rather than getting stopped-out at what is often the worst time.

    If stop losses are hit more than say, 20% of the time, then the exit strategieS (and there should be several to cater for different market conditions) are simply not working too well. If stops are hit 100% of the time, then obviously there is no exit strategy.

    And, depending purely on stops to exit trades is akin to your broker taking massive commissions out of every single trade - win or lose.

  4. Hi Jose,

    Thanks for sharing your excellent analogy.

    By the way, I've been a fan of your MetaStock coding for a long time.


  5. Hi Brenda,

    Just found your blog recently and have been catching up on all your posts. Great blog! I love the philosophical approach and sheer breadth of subjects you explore. Must say, I'm curious to know what/how you trade, and given said breadth, I don't have the slightest clue!

    I agree with just about everything said in the article and comments. I would add (as a trading systems developer) that figuring out workable stop strategies for any given system takes a much higher percentage of the development time than most people would expect.

    Strategies that go with the trend (swingtrading, breakouts) are compatible, and I've found tighter, more aggressive stops work especially well with breakouts, since price retracement is pretty much evidence against it being a "real breakout".

    Mean reversion strategies are in my experience practically unworkable with stops. I prefer to manage those risks by position size, being market neutral, or with defined risk bull/bear option spreads, if a possibility.