How Effective Are Stop-Loss Orders?
A stop-loss order is a type of order used in trading to limit an investor’s losses or to take a profit. It is an instruction to sell a security when it reaches a certain price level, known as the stop price. When the stop price is reached, the stop-loss order is automatically executed, and the security is sold at the current market price.
Stop-loss orders are a popular risk management tool for traders, as they help to minimize potential losses in the event of an adverse price movement. By setting a stop-loss order, traders can define their risk tolerance and limit their potential losses to a predetermined amount. A trailing stop-loss order can also be used as a profit-taking strategy.
Reference [1] examined the effectiveness of stop-loss trading strategies. It utilized 2 types of stop-loss strategies:
SL1: a sell order is generated when the price of the day is less than the average of 95% price over the previous three days.
SL2: a sell order is generated when the price of the day is less than 95% of the highest price of the previous three days.
The authors pointed out,
Our findings are consistent with those of Lo and Remorov (2017), who demonstrated that tight stop-loss strategies underperform the buy-and-hold policy in a mean-variance framework due to high trading costs. In a nutshell, this study confirmed that the return of SL2 strategy in quarterly makes higher profit in comparison with two other strategies.
We think that the results are interesting, but not conclusive. Also note that the studies have been performed on the Iranian stock market. It would be interesting to see the results from the developed markets’ perspectives.
As far as we’re concerned, we would limit the use of stop-loss orders since they make the PnL highly path-dependent, thus trading strategies become more complex to analyze. We prefer hedging strategies instead.
Let us know what you think in the comments below.
References
[1] Mohammad Amin Teimoori Boghsani, Abdolmajid Abdolbaghi Ataabadi, Majid Ameri, Effectiveness of Stop-Loss Trading Strategy VS. Buy-And-Hold Strategy: Evidences of Top 30 Companies at TSE, Preprint
These stop loss rules are overparameterized, highly heuristic, and as you rightly point out, apply to a set of markets that likely do not represent the experience in global markets.
Using continuous price-based signals which naturally have a stop-loss like effect would remove the need for using separate stop loss rules and remove the path dependency