In my book Short-Term Trading Strategies That Work, we created a small firestorm with a chapter that was titled “Stops Hurt”. The chapter showed statistically that stops on pullbacks hurt performance (since publishing this test in the book many others have replicated it). Even stops placed 50% away (which few would even consider a stop) hurt performance.
Short-Term Trading Strategies That Work has been one of our best-selling books, surpassing even our high expectations. In no way though did we think the chapter on stops would become one of the chapters so widely discussed.
First, let me state right here that as of this writing (2018), I trade strategies that use stops. They usually also involve profit targets which means the position is held until a profit target is hit or the stop is hit. A strategy for example that has a 10% profit target and a 10% stop and is correct over 50% of the time will make money (commissions not included). Get up to 60% correct and you have a healthy trading strategy.
Therefore I’m not “the guy who doesn’t use stops” as many mentioned in their discussions on the book. But, I am the guy who strongly feels (and more importantly sees statistically) that in many, many strategies, traders assume that as long as they have stops in place they are fully protected. The reality is they are not.
What are stops? Stops are partial insurance. Non-professionals often believe they provide full protection. In reality though, the equity markets are closed more hours than they are open. If something major occurs when the markets are closed, stops are often useless.
For example, imagine a trader being short a downtrending, poor-fundamentals stock at $30 . They did all their homework. Bad company, minimal earnings, cash-burning, terrible technicals, and on and on and on. They’re really onto something here on the short side, right? They tell themselves they’ll risk 10% shorting the stock at $30 putting in a “protective stop” at $33. At best though, possibly they’re “protected” for the 32 1/2 hours a week the market is open (assuming nothing extreme occurs intraday).
Now let’s imagine this same company is in an industry and the leading firm in the industry is outside the US and is hypothetically looking to enter the US as it does its global roll-up. Poor-technicals & poor-fundamentals company is approached, and management’s headache is now a bonanza. They get offered $60 a share over a summer weekend on a buyout (and yes, this similar scenario played itself out in 2016).
The stock opens on Monday at $58 and eventually rises to near $60. How did that “protective” stop at $33 work out? It’s called losing nearly 100% overnight on a position (and sadly this happens to traders all the time both on the long and the short who rely on stops as their only protection). And in this case they got lucky. The buyout could have been at $90 (or higher!) and they would have lost 200% or more overnight.
Here’s a recent high-profile example on the long side. Look at the price history of the inverse long (short) volatility ETN – XIV. Thousands of traders owned that ETN on Feb 2, 2018 when it closed at $99. Many of these traders had their “protective stops” in place just under that price. The problem is the stock opened at $8 the next day. A 90% loss that was not supposed to happen because a “protective” stop was in place.
Here’s the bottom line. Stops are band-aids that protect your skin when you scrape your elbow. Stops are useless though when a major car wreck occurs.
In Short-Term Trading Strategies That Work, we showed definitively with data-driven test results that stops hurt. Yes, they potentially have a place in one’s portfolio, especially if other risk management tools are associated with it. As a stand-alone risk tool though, they’re at best band-aids that cover the scrapes much of the time but leave one exposed to the more serious hits a position can take.
Is there a better solution? Is there a better way to protect one’s positions? In my opinion (and many professional traders’ opinion), there often is. And we’ll cover this in further depth in a future issue of the Connors Research Traders Journal.
Enjoy your trading!
Larry Connors
Connors Research LLC
P.S. Are you looking for private one-on-one trading mentoring to further improve your trading? If you are call 888-484-8220 ext. 1 for additional details.