One of the most deeply ingrained beliefs in trading is that stop losses are necessary for managing risk and holding back the capital. For years, traders have been taught that a stop loss acts as a safety net in preventing disastrous losses; yet time and again, countless backtests have demonstrated that using a stop loss may actually harm your performance. Why does a device designed to supposedly “limit risk” so often instead diminish returns? And if stop-loss strategies are not the answer, what alternatives do traders have to more effectively manage risk in a way that doesn’t incidentally reduce potential returns?
We will discuss why using a stop-loss strategy may actually degrade trading performance and increase draw-downs, despite their widespread use. We shall show backtesting data and a few real examples of how traditional stop loss strategies sometimes end up hurting profitability and providing missed opportunities. More importantly, we’ll introduce several alternatives to the stop loss which allow traders to reduce risk without reducing their returns. Those methods include diversification, trading different asset classes, adjusting position sizes, and employment time exits.
All this and more become possible as you understand for the first time the real impact of stop losses and how they will affect your long-run performance. Need some more juice to take the returns to the higher plane, some more protection from drawdowns, or freedom from behavioral mistakes? We shall guide you through these alternatives as well as help you rethink your trading strategy. All set to discover how to better manage risk and handle stop losses without using the traditional approach to stop loss?.
The Problem with Stop Losses in Trading
Everyone knows that the stop loss has a great function of limiting potential losses by automatic sale of the position once it has gone below a certain level. The idea is quite simple: to protect capital, this must be done as early as cutting of losses. The practical reality is much more complicated, though. While stop losses are excellent risk management tools from an intuitive perspective, in reality, they often are accompanied by unintended consequences that will hurt your long-term profitability.
The main problem that comes with stop losses is being forced out of a position at exactly the wrong time. In volatile markets, a small price move might trigger a stop loss, and you sell out of a trade prematurely. This is particularly awful in mean reversion strategies, in which prices are more than likely to revert back up to their trend following a short-term step back. A stop loss here can give you a loss right before the market rebounds and you, theoretically, make back much of your profit.
Let’s use an example:
You’re trading with a strategy using a buy in after a deep drop in price (typical mean reversion setup). It drops a few more ticks after it gets into the trade and triggers your stop loss, so you get out of that trade, but three days later, it does a huge takeoff. You probably, once again, miss the kind of trade you would like to get in on. This is one of those trades you call a “bummer” trade where you will lose on the exact bottom of the market, only to recover without you.
Backtesting Results: Stop Loss vs. No Stop Loss
We performed a backtest based on the effect of stop losses on performance, using the SPY ETF tracking the S&P 500 index. The approach used in the backtest was mean reversion, with a comparison of performance both with and without a stop loss.
Equity Curve Comparison
Without Stop Loss: The equity curve minus a stop loss is getting even more flat and smooth.
It will ride out the market over volatility and compound.
With Stop Loss: Now when applying a stop loss, the equity curve is more erratic. Although it might cap your short-term losses, you are also capping yourself to potential upside gains and force you out of trades at bad times
Key Performance Metrics:
Annual Return: The annual return fell from 12.5 percent to 10.5 percent with the stop loss.
Maximum Drawdown: But, curiously, maximum drawdown increased from 22% to 23% with the stop loss, so it did not actually increase risk as one might intuitively think.
Why Stop Losses Often Fail
Market Noise: In noisy markets, stop loss triggers might be triggered by unnecessary short-term price movements. Consequently, investors are “stopped out” of positions just when a market reversal is about to happen.
Compounding Effect: Every time stop-loss closes a trade at a loss, this is minus one possibility for compounding profits. Small losses large affect long-run returns, very much so with mean reversion strategies because prices generally bounce back after slight corrections.
Behavioral Bias: Traders get emotionally attached to the stop loss, focusing on protecting themselves against short-term losses rather than maintaining a disciplined long-term strategy. This leads to impulsive decisions and overemphasizing risk controls that don’t improve performance in the long run.
Alternatives to Using a Stop Loss
Although stop-loss seems to be an indispensable management of risk component, sometimes there are alternative ways that may be used to reduce risk without a reduction in the profitability. Let’s see some of the most effective methods:
- Diversification Across Asset Classes
Making varied trades in different asset classes, such as stocks, bonds, commodities, even gold, exposes you to the risks of just one single asset. This way, your portfolios are not over-invested in the space of any one market, so you can ride out downturns in particular sectors or industries. - Unrelated Trading Strategies
Whereas a stop loss is applied at individual trade levels, you can use uncorrelated strategies, so ideally those will do well under divergent market conditions. Clearly enough, such strategies should not be highly correlated with each other, and when one is underperforming, another is doing exceptionally well. This approach to diversification will spread risk and potentially have increasing returns while lowering overall volatility. - Time Exits
Another good method is a time-based exit on your trades. That’s leaving your position for a specific amount of time, regardless of price action. Most trading edges fade with time, so a time exit keeps the trades from running too long and thus avoids unnecessary risk. - Diversified Position Sizes
Position Sizing Risk Management One can further control risk by positioning oneself appropriately. You actually make each of your trades small enough so that a loss at this size will barely be felt in your overall portfolio. A smaller position size also helps unattach one from emotional attachment, which now focuses more on the strategy itself rather than the dollar amount at risk. - Lower Trade Size
Trading smaller position sizes makes sense if you are a new trader or just generally like to keep the overall risk of your portfolio low. You’ll be able to test strategies at lower levels of risk exposure so that you avoid major losses in volatile market conditions. Smaller trade sizes also cut down on the temptation to make greedy decisions based on short-term price swings.
Case Study: Achieving Higher Returns with Lower Risk without using a stop loss
We also did a backtest of the SPY ETF using a mean reversion strategy. As shown, results were impressive: the strategy, without any stop loss, achieved an impressive $1 million in 20 years from an initial $100,000 investment, with an average annual return of 12.5%. Thus, maximum drawdowns were at 22% as compared to around 55%, the usual drawdown often seen with a buy-and-hold strategy.
We then added three other non-correlated strategies that traded QQQ, XLU and TLT (bonds). Adding these strategies further refined the equity curve overall. Returns now encompassed:
Annual Returns: 16.5%
Drawdowns: Very much reduced
Of course, this is a fantastic demonstration of how blending of various strategies reduces risk and enhances returns without the usage of a conventional stop loss.
Conclusion: Redefining Risk Management in Trading
The facts are that the stop loss, though widely used, actually diminishes performance and does not provide protection from risk as traders would expect. Alternative diversification strategies, including uncorrelated strategies, time exits, and adjustments to position size, could maintain a risk management profile without sacrificing the potential to gain high returns.
Having a robust trading strategy that can adapt to any market condition with the ability to focus on compounding returns rather than minimizing short-term losses shall always be the key. Whether using diversification in your portfolio or different trading timeframes, there are several ways through which you will manage risks far better compared to solely relying on a stop loss.