Stops – When Not to Use Them

Using a stop on a position is a very popular risk management technique used by traders. My research and experience has led me to believe they are appropriate for some – but not all – types of trades. Today I will discuss when I believe they aren’t appropriate.

In Larry Connors' new book, “Short-term Trading Strategies That Work”, he dedicates a chapter to stops. It’s entitled, “Stops Hurt”.  The chapter discusses how Larry’s research team ran hundreds of tests to try and find optimal stop levels. In doing so, they came to the conclusion that for the trades they were looking at, the optimal stop was consistently none at all. In every case they found that instituting stops hurt system performance.

You should keep in mind that Larry Connors trades mean reversion strategies. Much of what I do is mean reversion based also. For instance, the Catapult system which makes up the CBI looks to buy stocks that are undergoing capitulative selling. It enters long positions in stocks or ETFs that are extremely oversold. When I first designed the system in 2005 I went through a massive series of tests to find a way to successfully incorporate stops into the methodology. Like Larry I failed to find a stop technique that would enhance the performance of the system.

I’ve gone through numerous other exercises and found the same thing time and time again. When looking to trade overbought/oversold techniques, stops generally don’t work well. If the system suggests the security should bounce when it drops to $20 and it continues to $18, then it is REALLY overdue for a bounce. Any level of stop ensures you are selling an extremely oversold security that is making a low. Those are buying conditions for oversold systems – not selling conditions.

One stop technique for oversold systems that I will sometimes use that in testing hurts performance less than the other techniques I evaluated is this:

Wait until the security bounces for a bar or two. Look for a higher high, higher low, and higher close – or at least 2 of those 3. Then place a stop under the swing low that was just made. In cases like this even if the security doesn't hit your target exit price, it still ensures that you won’t have to suffer through the entire next leg down. While it seems logical and can sometimes help avoid catastrophic trades in the long run, you’re normally better off just waiting for the mean reversion to occur and exiting at your target level.

Not using stops does not equal not controlling risk. Position sizing becomes very important. Traders could also consider using options to trade their short-term positions. Options provide a natural stop (zero). I wrote a series back in the spring (when the VIX was a lot lower) on how I sometimes use options for my short-term trading. You can find the link here:

While stops do not work well for overbought/oversold trading, they DO work well with breakouts or trend following systems. Traders that buy on a pattern breakout do so because their analysis indicates a trend could emerge in the stock or security they are trading. A reversal back into the base or below it would invalidate the pattern from a technician’s standpoint. Therefore, in such cases I believe a stop is completely appropriate. Once the pattern “fails” you should no longer be in the trade. Of course some people may want to give a little extra leeway rather than putting a stop right at a support point, but even so, there is a point where the breakout simply didn’t take.

For my own breakout trading I tend to use very tight stops. I also tend to show little patience for a trade to work once I enter it. Most successful breakouts have a tendency to work right away, and when the market environment is conducive to breakouts there’s just no point in sitting around with dead wood. I’d rather exit with a small profit or loss and try the next one.

The edge in breakout or trend trading is not in the winning percentage. It’s in the risk/reward. A big winner can gain several hundred percent if it goes on a tear. That makes up for an awful lot of scratches and small losses. As an example, in 2003 I did a lot of breakout trading. Cup & Handles, Flat Bases, High Tight Flags, Double Bottoms, etc. – all based primarily on daily bars. It was a tremendous year for trading breakouts because the ones that took caught fire rather quickly. It was also one of my best market years. Yet, at the end of the year I went back and tallied the percentage of breakout trades I took that “worked”.  In other words, they did better than a very small gain or scratch. My success rate? A little under 15%.  And it was a great year. Why?  Tiny losses and massive gains.

Everyone’s style is different and someone with more patience would likely have had a better win rate, but the win rate wasn’t important. What was important was controlling the losses, and one way to do that was through the use of stops.

-- By Rob Hanna from Quantifiable Edges. Rob Hanna has been a full-time market professional since 2001.  He has served as president of Hanna Capital Management, LLC since that time.  He first began publishing his market views and research in 2003.  From 2003 to 2007 his column “Rob Hanna’s Putting It All Together” could be found twice a week on TradingMarkets.com. In January of 2008 Rob began Quantifiable Edges.  In 2012 Rob opened his 2nd website, Overnight Edges.  Both sites use historical analysis to asses current market action and odds.  Rob utilizes price action, volume, breadth, sentiment, seasonality, liquidity flows and more to conduct his research.  Some of the indicators he uses are well known and publicly available.  Others were created in-house.  His work has been widely referenced and quoted over the years, and is often linked to in blogs, tweets, Stocktwits messages, magazine articles and more.  Below are some other places you may have seen some of Rob’s work.

  • BlueHorseshoe says:

    Trading these types of strategies myself, without stops, I would definitely echo your comment that position-sizing becomes paramount as a method of risk control.

    One type of risk that I find intriguing and impossible to quantify is the point at which an account failure ceases to be significant in a context of broader financial failure.

    For instance, if you’re trading a mean reversion strategy with an un-leveraged product such as SPY, and you use your entire account balance to buy the security, then the value of the S&P has to fall to zero in order for you to lose all the money in your account. Which is (let’s hope!) highly improbable.

    However, if the S&P does fall to zero, it’s pretty much the end of the world as we know it. Your trading account will probably be low on your list of priorities at that point. In fact, even if you pass on the trade and remain in cash, your broker has probably gone under and you’ll have lost the money in your account anyway.

    There’s really no way to quantify the point at which the risk of systemic financial failure overtakes the risk of wiping out a retail trading account.

    • Kolokola says:

      SPY doesn’t have to go to zero. If you lose 10 times 10% of your capital you are done. Trading without stop-loss involves suicidal tendencies. Sometimes those who say that actually do not trade. Go to a prop firm and tell them you are not going to use stops. They will kick you out.

      • Mark says:

        Kolokola,

        What are you talking about?

        First, 10 times 10% of your capital is a 100% loss. If, like BlueHorseshoe said, you used your whole account balance to buy SPY then SPY would have to fall to zero for you to lose 100%. You’re saying exactly what he did.

        Second, seeing that you’re replying to BlueHorseshoe’s comment, respond to it! Don’t just dogmatically state “trading without stop-loss involves suicidal tendencies.” He gave reasons why it might just make sense. He said it would be the end of the world. He said your broker has probably gone under by that point, which means you’d have lost the money anyway. He said money would probably be low on your list of priorities.

        If you disagree then address his points since you replied to his comment.

        Besides, given that instance, I’m guessing suicide would not seem like such a bad idea for many.

  • Ben Little says:

    I can’t remember where I heard this from recently, but I thought it was a great analogy for stops and their purpose. It was something to the tune of “stops are simply just a form of insurance, and just like your car insurance, home insurance, etc…you have to pay for that insurance. The stops are protecting you from the worst case scenarios, just like your home insurance coverage is protecting you from a tornado, earth quake, etc. but the fact is that most people will never need to use the insurance on those worst case scenarios.” And another point is that most of the time, the huge loses occur from big gaps (if trading equities) that even if you had a stop, it wouldn’t help you at all because your already stuck at that point. I think you (Rob) hit the nail on head when you talked about stops (not even so much mean reversion vs trend) but in reference to systems that have an edge simply from a huge risk/reward profile. I have a mean reversion system that I currently trade that tries to get long after a new lod has been made with a couple filters. It’s only right about 20 percent of the time, but the average loser is only 150 bucks, and the average winner is over 1200 bucks. So for that system to work it has to have a stop, but for the vast majority of mean reversion systems, a stop will greatly hurt the performance.

  • Jack says:

    To the author:

    “As an example, in 2003 I did a lot of breakout trading. Cup & Handles, Flat Bases, High Tight Flags, Double Bottoms, etc”

    Have you traded since? I don’t see how these fit in a system trader forum.

    “My success rate? A little under 15%. And it was a great year.”

    In other words you were lucky. You got 1 out of 7 right. A random trader will get 1 out of 2 right. You had a bad method but then you hit a good trend probably by accident.

    So this guy is a lot worse than random trade he admits, in 2003 he got a trend by accident probably because his method was wrong 6 out of 7 times and he thinks this is a good lesson for other traders. Next time you will not be that lucky if you trade in fact. HFT is 99.99% win rate. It’s the only trading method that currently works. Go tell them you have a 15% win rate. They will ROLFLMAO.

    • Dracarp says:

      Congrats to your HFT successes! If, however, you are not profitable with other approaches, this does not mean others can’t.
      The low 15% win rate related to the tiny stops. Larger stop -larger win rate. He just liked to trade this way. …and as you have seen, he did not mention his overall return for the year. If he would, you would probably not believe…

  • Contrarian says:

    LOL LOl

    Ray Dalio thinks 60% is low win rate:

    “Still, even with 40 years’ experience managing money Bridgewater still makes mistakes, and, by management’s own admission, even Bridgewater’s best ideas are only right around 60% of the time:”

    http://www.valuewalk.com/2015/06/ray-dalio-part-two-bridgewater-grows/

    Dalio think one should be right 80% of the time for best performance.

    “My success rate? A little under 15%.”

    15%? LOL

  • Kolokola says:

    “Not using stops does not equal not controlling risk.”

    It means exactly that.

    • Jeff Swanson says:

      Stops are not the only way to control risk. There are other means to control risk as pointed out in the article.

  • >