Stop-Loss Orders: Are They Really Necessary for Stock Traders?

In most trading books, you will learn that using a stop-loss order for every trade is necessary to protect against excessive losses and to determine position size. However, practice and backtests in the stock market show that in many cases, implementing a stop-loss order worsens strategy results. In this article, we will comprehensively discuss the topic of stop-loss orders in the stock and ETF market.

What is a Stop Loss Order?

In short, it is a predetermined price level below which we do not want to incur further losses. When the price falls to the stop loss level, the stop loss order automatically converts into a market order, selling the asset and closing the losing position. The example given here pertains to long positions, for short positions, the stop loss order and loss cutting occur above the opening price.

When is a Stop Loss Order Needed?

A stop-loss order serves to define and protect against risk at the position level, so it is generally valid wherever we have high positions relative to the capital used. For example, when trading highly leveraged instruments like futures contracts, where the value of 1 ES contract (E-mini S&P 500) is over $200k and our capital would be, for example, $20k, a stop loss order is required because a 10% price movement in the opposite direction would wipe out our account. The goal is to not risk more than X% of our capital in a single trade (usually 1-3%). Similar indications for using a stop loss order will be relevant for any large positions opened, for example, in intra-day trading, where the stop loss level allows for determining position size adjusted to the accepted risk level. Using a stop-loss order will also be very appropriate for intra-day trading in stocks. Typically, large volumes are used in individual positions to achieve the desired result on a quick move.

Challenges of Stop Loss Orders in the Stock Market

However, the situation may be different when it comes to multi-day trading in stocks.

Price Gaps

Stocks are not traded around the clock, but only during the session from 9:30 am to 3:30 pm New York Time. I am omitting off-session trading in this analysis, which is reserved for more advanced players.

Naturally, and commonly, there are price gaps between individual sessions that completely disregard our stop loss level. For example, we bought shares of company X at $100, setting the stop loss at $97, but the market opens the next day at $90. Our stop-loss order is immediately executed at that price. We assumed a risk of -3%, but we ended up with a loss of -10% just like that. Such large price gaps (up or down) are not uncommon, especially for smaller companies.

Hunting for Stop Loss Orders

Another disadvantage of stop-loss orders, especially when we set them manually at obvious levels (swing lows), is exposing ourselves to manipulation by institutional players who are looking for "willing" buyers for their shares. They often push the price below obvious support levels just to trigger the stop-loss orders of typical retail investors, i.e. swing levels, buy large volumes of shares, and then fly away with the price. Protection against such maneuvers is to use stop-loss orders at non-obvious levels, for example, by using ATR-based stops or... not using stop-loss orders at all, as we will discuss shortly.

Backtest Results

Backtest results prove that using stop-loss orders in stocks can significantly worsen strategy performance.

An example from the Stock Monthly Mover (MM%) strategy:

The strategy still works with the use of stop-loss orders! That's good news🙂.

However, practically all parameters with the use of stop-loss orders are worse. Total profit and Ret/DD ratio are lower by almost half. This strategy is not an exception, similar results can be achieved in many stock-based strategies and instruments based on them. Juggling the size of the stop-loss order is also not usually an effective solution until we set it so far away that it's as if it wasn't there at all (the so-called catastrophic stop).

Why is this the case in the stock market? Because stocks have a reversal nature. So, after a period of strong decline, there is usually a rebound. This makes sense in the case of businesses. If a company's stock price suddenly drops by, for example, 20%, there will always be buyers willing to purchase shares at a "discounted price," and that's why the price usually rebounds. For traders, selling during such a rebound is often a more effective way to exit a position than cutting losses during a decline.

What is More Effective Than a Regular Stop Loss

This brings us to the crux of the matter. What is more effective than cutting losses using a stop-loss order, and how can we protect ourselves from very sudden price drops in individual stocks?

Statistics show that there are quite effective alternative methods of closing positions:

• Exit Condition: This is the basic method, closely dependent on the strategy. Exit when the conditions that ensure profitability and resilience to the strategy are met. The exit condition can be purely technical, fundamental, or complex. At this moment, we focus on pure technical setups.

  
  

• Time-based Exit: If the exit condition does not occur, close the position after X days or on a specific date (e.g., for seasonal strategies). This condition is often used as an addition to the standard conditions. It is not usually applied in trend-following strategies, where the aim is to let the trend develop until it exhausts itself.

  
  

• Trailing Stop: This method involves setting a stop order at a certain distance from the open position. It moves parallel to the position when the market moves in our favor, but stops and closes the position when the market starts moving in an unfavorable direction. Similar results can be achieved using selected exit conditions.

  
  

• Account-level Stop Loss: This practical technique involves closing all positions if the entire portfolio of strategies/accounts drops below a predetermined safety level. Advanced systems like Algocloud allow setting such a safety measure. However, careful consideration should be given to its use so that it is used only in strategically threatening situations and is not activated in the case of normally occurring price declines.

Diversification Instead of Stop Loss Orders

As algorithmic traders in the stock market, we have a great risk management tools without using a typical stop-loss order.

The most important tool is DIVERSIFICATION, which applies to both instruments and, above all to strategies.

In the case of trading futures contracts, diversification is difficult unless you have very large capital. Only when trading on many low correlated strategies and instruments simultaneously can good diversification results be achieved. Some try to bypass this by using CFD contracts, but they can encounter enormous problems related to explicit and hidden transaction costs on these unregulated instruments.

However, if you are trading equities, including stocks and ETFs, the situation is completely different. Extremely low costs, fractional shares, and strict regulations make this market accessible to practically anyone who wants to develop in investing and algo-trading.

Positions can be scaled from as little as $100 to $100M+, and algorithmic trading allows for easy implementation of multiple strategies simultaneously, each trading on multiple instruments, all with full automation, stability, and transparency.

For example, if I have 5 different Stockpicker strategies running, each with 10 open positions at any given time, I have 50 different positions, each living its own life (following entry and exit conditions according to a previously tested strategy). With equal capital allocation, this means that my exposure to a single stock within one strategy is a maximum of 2%. So, if a stock experiences a minus 30% price gap, my capital loss from that will be only -0.6%. In practice, it may happen that eg. two strategies will trade the same stock at the same time, but the risk of problems with a particular stock is significantly diversified.

Summary

I don't want this article to sound like I am against stop-loss orders. I have used them and will continue to use them when trading large individual and leveraged positions. I also recommend using them in all shorting strategies where there is no natural limit to price movement against us.

But the fact is that backtest results prove that using stop-loss orders in stocks can significantly worsen strategy performance. Check for yourself in backtests how stop-loss orders affect the behavior of a well-diversified long-type strategy in the stock market and form your own opinion on the matter.

Implementing stop-loss orders and experimenting with them is simple and can be easily done in Algocloud or SQX. If using stop-loss orders has a positive impact on results without compromising the robustness of the strategy, that's great. However, if the results with stop-loss are significantly worse, it is worth considering increasing safety through diversification instead.

This brings us to another point, managing risk for the entire portfolio of strategies is a more important challenge than a stop-loss order on an individual position. This can be done by having strategies and the instruments used by them as lowly correlated as possible, but that is a topic for another article.