Pros and cons of stop loss orders

A two-sided article written by Alex Foster and The White Coat Investor taking opposing views on the usage of stop loss orders.

Alex takes the pro-stop loss side, concluding:

Investing is a balance act of risks and rewards. Investors can reduce downside risks while maintaining the potential for rewards available by using a trailing stop ladder. The benefits of using a trailing stop ladder outweigh the negatives. While laddering out of a position with staggered trailing stops does not eliminate risks, it does reduce the size of losses significantly during a bear market.

On the other side, The White Coat Investor cites six reasons he doesn’t sue stop loss orders:

additional costs

additional taxes

additional complexity

stop loss orders are a form of market timing

beware of getting whipsawed

watch out for gapping

Alex includes a final rebuttal addressing each of the arguments. A big part of of the decision comes down to how active and disciplined you can be with your investing. If you truly believe in your investments for the long-term, there’s no need to bother. If you’re looking short-term and/or willing and capable of trading in-and-out on a consistent basis yet don’t want to watch the market all day, stop losses can be used effectively.

Read more atĀ Stop Loss Orders – Pro/Con Series at The White Coat Investor.

Findings from 3 research papers on stop losses

From a 2015 post at Quant Investing, a look at 3 research papers on the use of stop losses.

Study 1: When do stop loss rules stop losses?

What they also found was that the stop-out periods were relatively evenly spread over the 54 year period they tested. This shows you that the stop-loss was not just triggered by a small number of large market movements (crashes).

Study 2: Stop Losses, Trailing, and Buy & Hold compared

Trailing better than traditional
Only at the 5% and 10% loss levels did the traditional stop-loss perform better than the trailing stop-loss. At all other loss levels the trailing stop loss out performed, most notably at the 20% loss level where it performed 27.47% better over the 11 year period.

Study 3: Stop Losses in Momentum Investing

The stop-loss momentum strategy also completely avoided the crash risks of the original momentum strategy as the following table convincingly shows.

Click image to enlarge

NoteĀ that if you followed a stop loss strategy you would have made a small profit when the momentum only strategy lost nearly 50% and 40%.

The studies actually convinced the author to change is opinion on stop losses:

This has been a rather long article to come to a very clear and simple conclusion: Stop-loss strategies work

As you have seen:

  • When applied to a 54 year period a simple stop-loss strategy provided higher returns while at the same time lowering losses substantially
  • A trailing stop loss is better than a traditional (loss from purchase price) stop-loss strategy
  • The best trailing stop-loss percentage to use is either 15% or 20%
  • If you use a pure momentum strategy a stop loss strategy can help you to completely avoid market crashes, and even earn you a small profit while the market loses 50%
  • Stop-loss strategies lowers wild down movements in the value of your portfolio, substantially increasing your risk adjusted returns

via Truths about stop-losses that nobody wants to believe at Quant Investing for Value, Momentum, Quality and Growth stocks