A number of years ago, I published a research study entitled “Stops Hurt”. I know many if not all of you are aware of this study which basically showed that stops lowered the performance of most mean reversion strategies no matter how far away the stop was placed.
In fact, stops placed as far away as 50% hurt the performance of most mean reversion strategies. As I’ve stated a number of times, smaller position sizing and/or options are better protection vehicles than using stops and the data backs this up. Stops do nothing to protect you from overnight risk and they also tend to stop traders out before reversals occur, therefore accumulating losses upon losses.
Let’s now race ahead to Thursday May 5, 2010 when the market dropped 1,000 points intraday. Hundreds of thousands of “Protective Stops” were triggered which locked in the losses for those stopped out. And they provided healthy gains to those who were on the other side of those stops (I know many of you are among those fortunate traders who bought stocks at tremendously low prices that day). And once Monday’s 400 point rally occurred, followed by Wednesday’s rally, the gains for many were substantial.
The financial markets industry (including the brokers) mean well in advising using stops. But they are naive and have led a generation of traders (including professionals) into believing that stops protect people. Maybe they do for some days, 6 1/2 hours a day (and they actually do for some trend following strategies). But Thursday proved that they hurt traders badly in reversing markets. Beyond that, they provide no protection to you overnight and over the weekend. They’re an expensive price to pay and simply following the statistical evidence presented years ago allowed many of us to be able to buy stocks very cheaply on Thursday and take these positions along with our ETF positions into Monday’s tremendous rally to the upside.
On Saturday the Wall Street Journal did the following story. Titled “When Stop Loss Trades Backfire on Investors” they shed some light on the downside of stops. This information is late in coming from them (always after the fact) but at least it’s now out there. Fortunately, this is quantified information that many of us have had for years as taught in our books, courses and classes.
Please remember: Data Drives Decisions. As you have seen over and over again, it’s the single best way to trade and to invest.
Here’s the article for you to enjoy: When Stop Loss Trades Backfire on Investors
The above is from Larry Connors’ Daily Battle Plan, published every morning before the market opens. For more information or to launch your own free, 7-day trial, click here.
Larry Connors is CEO and Founder of TradingMarkets.com and Connors Research.