Stops Hurt!
Larry Connors' Trading Lesson of The Day | September 11, 2024
In the past two trading lessons, we looked at one of the greatest hedge fund/traders in history stating that stops are “the dumbest concept” he’s ever heard, along with me walking you through the fact that stops do not protect you for over 80% of the hours in a week, which was likely eye-opening for you.
The first is the strong opinion, backed by real-world results, from a hedge fund legend (Stanley Druckenmiller).
The second is reality. Stops are fine intra-day. But regular hours for the US stock market makes up less than 20% of the hours in a week. Anything crazy that happens in the remaining 80+ percent hours of the week runs the risk of the market or an individual stock substantially gapping in the wrong direction. Those 5%, 7%, and 10% stops become market orders on the opening. And this can wreak havoc in your portfolio.
Now let’s go to the third part. Data.
My research company has run hundreds of these tests over the past 20+ years. Nearly every test has shown the same in overnight trading…STOPS HURT!
In my book Short-Term Trading Strategies That Work, written with Cesar Alvarez, we showed one strategy example of what could literally have been hundreds of examples.
We ran a simple large sample size test on a very basic mean reversion strategy.
The rules were:
1. We looked at all liquid US stocks over a 15 year period.
2. The stock must be above its 200-day moving average.
I’ve documented in writing beginning in 1999 that stocks, on average, perform better on a short-term basis above their 200-day ma. What is common knowledge today, was first quantified by us a quarter of a century ago. It still holds true today.
3. If the stock closed on its 10 day low (it pulled back) buy on the close.
4. Exit when it closes above its 10 day moving average. NO STOPS WERE APPLIED.
We then tested this same strategy and added in stops ranging from 1% all the way up to 50% (is 50% even a stop?).
In every single case, the use of stops lowered the performance. Even the 50% stop had a lower performance than no stop!
We first published this test and concept a number of years ago, and it’s been updated by us and many others over the following years.
In fact, I recently got a note from a professional trader with a strong data engineering background. He told me that for years he came to the same conclusion – no matter which of his systems he created, stops lowered its performance.
He went on to say that until he read the chapter from Short Term Trading Strategies That Work, he thought he was the crazy one. Everywhere he looked, stops were advocated – yet in his own trading all they did was accumulate losses and lower his overall performance.
Here is a PDF from the book chapter for you to read about stops and how the data shows they overall hurt performance:
Yes, having in stops will often stop traders out of positions before they go even lower. When they do, that feels good. But, they also “accumulate losses” by stopping out positions that reverse higher, especially oversold positions above their 200-day ma.
Look closely at the test results in the chapter. They don’t “cherry pick” examples as so many individuals do when they show examples of stops – it’s full sample size, unbiased data.
Also, we (and many others over the years) have run various trading tests coming to the same conclusion.
7 Additional Points…
1. Again, as I mentioned in yesterday’s lesson, if you use stops and you’re successful with them, keep using them. You know what’s best for you.
2. Everything mentioned here applies to overnight trading, especially US ETFs and equities.
Day Trading is a different story. (for example, the overnight risk factor is eliminated).
3. There’s a psychological safety in knowing a stop is in place. Just don’t be complacent and believe, as many have told you, that “you’re fully protected”. You’re not! Especially from overnight risk.
4. Ask yourself, how did one of the greatest traders in history, with audited returns, put in multiple decades of tremendous results (without a single year of losses) do so without ever using stops (some of his ways will be shared with you tomorrow)?
5. One of the major reasons why stops tend to lower performance is that they accumulate losses. The times they work are not enough to offset the additional times the position is stopped out, the loss is booked, and then the position reverses to what would have been a profit. Sound familiar?
6. There’s a reason Ken Griffin (Citadel) just paid $670 million for three lots in the Brickell District of Miami. As I’m writing this I’m staring at the main lot right now which will house his world headquarters – it’s across the street from my office. A tremendous amount of wealth has been created over many decades trading on the other side of retail traders as Citadel has done. Don’t add to it.
7. Follow the data! It’s what every successful quant hedge fund in history has done and continues to do so today.
Tomorrow - Better Risk Management Strategies For You
In tomorrow’s trading lesson of the day, I’m going to share with you a handful of ways to potentially improve your trading results through the use of better risk management strategies than stops.
This way you’ll be empowered with the knowledge to make better trading strategies and decisions with the goal of enhancing your overall returns.
I’ll see you tomorrow!
Larry Connors
2024 The Connors Group. All rights reserved.
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