Stops Kill Performance

Every Tuesday Chuck releases a new Trader Tip video on YouTube. This week we will discuss: A really powerful belief for you to internalize is that money is actually just made up. Money is not real. What's really interesting in trading is a lot of people have the belief that markets are a zero-sum game.

You can read the episode transcript below or watch the video that follows.
If you have any questions, please reach out to us. We look forward to being a continued part of your trading education!

This is law number 10 of our Irrefutable Laws of Trading Success. The average retail trader over uses stops because they think that the stops protect them. They’re operating under a fallacy. Stops actually make their trades worse.

Let me explain. I was a partner in a company with Larry Connors. I did a lot of work with Larry Conners over the years, and Larry published this research back in 2005. He said: “For many years, I advocated the use of stops in trading. If you look at any of my published work until 2004, you will see the words “use stops” alongside most strategies.​

In early 2005, we started running tests with the hope of identifying the optimal stop levels to use. What came back though was completely the opposite (there is that word again) of anything we ever imagined. We have run hundreds of variations of stops tests and they all come to the same conclusion… When it comes to stocks and equity indices – stops hurt.”

Here’s one example. But Larry said he could show you hundreds of tests where they have the same behavior repeated.

So in this test, he showed a stock is above its 200, day moving average, and it closes at a 10 day low. So it’s basically a pullback above a 200 day moving average. So you’re going to buy it at a 10 day low, and you’re going to exit when it returns to the 10 day moving average, or when the stock trades X percent below the entry. So they went through they tested the different stock levels. So as you’ll see is in this system, with no stop at all, it has a 69.8% win rate in an average profit to loss of .58%.

Introducing the stop, smashed the size of the average profit loss. It became much, much smaller, but look at the win rate, the win rate got clobbered and eventually as the stock gets bigger and bigger and bigger, the win rate starts to come back to where basically around a 20% trailing stop, it’s similar to no stop, because it stops so big. But if you notice what happens is even though the wind rate returns to being what was comparable, the average profit loss, never gets back to the original love.

In my own testing, again, having run 1000s of tests on my own, it’s very, very rare that you ever see a system with a stop outperform a system without stop. This is why it’s one of the 10 irrefutable laws. Basically, you consistently see no stop, outperform a stop.

This is an example of a sample from a system that we teach in our Matrix Money Machine workshop. It is what we call the Simplified BB Gun, and you can see the Simplified BB Gun with a stop as a 50% win rate and an average win loss of 2.73, but the expectancy is 85 cents, which is really good. But if we take the stop off, you don’t have a stop, the win rate goes from 50 to 66%.

The average win average loss gets smaller because we’re taking bigger losses. But notice the expectancy, or the average size of a win goes from 85 cents to $1.06. It’s a 25% improvement, and this is pretty consistently what I see.

Let me share with you some tests from another sample we did. This is a system that we have called a TVA.

This system has an initial stop, but what we look at here is a trailing stop. We’re going to talk about two different concepts. Today we’re talking about the initial stop, which Larry just showed you, and I showed you data on, and then we’re going to talk about a trailing stop.

This is an example, Both of them have an initial stop., but System A, TVA with a trailing stop and an ATX exit, versus TVA with only an ADX exit. So in System B, you’re either getting out on an ADX exit or the initial stop. System A you’re getting out, initial stop, trailing stop, or ADX Exit.

What I want you to notice here is using the trailing stop, the win rate goes down. It goes from 40.91%. If we take off the trailing stop, we go to 45.45%. We get a four and a half percent improvement.

Also look at our average wind to average loss. Our average win to average loss is a little over two. It’s like 2.1, but if we take off the trailing stop, the average win to average loss goes from 2.1 to 2.7. Significantly better. So we have a higher win rate with a better average win to average loss, and this almost doubles the expectancy, the average R.

This is something I see all the time. All the time.

There’s a book called Alpha Brain by Stephen Duneier. This is a book that I love. Stephen and I have a lot of similar beliefs, and I love the way he expressed it in this book. So I wanted to share this with you, I highly recommend checking this book out. In the book Alpha Brain, How a Group of Iconoclasts are using Cognitive Science to Advance Business of Alpha Generation, what he does is he lays out a framework for how you should in general think about managing trades. It’s consistent with a lot of what we do.

We have an expectation that there’s going to be a trend, and then there’s an upper boundary around the trend and a lower boundary. What we expect is the market to oscillate. Trade within this range of expectations. What he’s doing is he’s recommending that we take profits inside the upper band of expectations, and we stop out below the lower band of expectations.

What he says is, “What do most traders do, instead of unwinding a position? They move their Stop Loss up, thereby effectively rebalancing the reward to risk. Now, while this appears rational it is not. The reason is not is that the upper and lower expectation bands represent discrete moments. What this means is the probability of spot trading above the upper band is disproportionately lower than the probability of a trading below the band. So if you want a high probability that your take profit will be hit, you set it inside the upper band of expectations”.

“On the other hand, the probability of spot trading just below the low end of your expectations is disproportionately lower than the probability of a trading just down to the lower band. Therefore, if you do not want to be stopped out, while your view is still in effect, you should set your stop loss just below the lower end of your expectation.

If you were to raise your stop loss, with the objective of rebalancing the reward to risk, you are shifting the probability of triggering the loss” from very low to very high. “While you are reducing the magnitude of potential downside”, while are you reducing the possibility of giving profits back, “you’re actually significantly increasing the likelihood that you will actually realize the loss” or realize the stop out.

One of the things that I always say is trading gives you what you’re trying to avoid. You have profit in a trade, you want to avoid given profits back, it gives you that. Then what happens is the market stopped, you stop out and the market takes off without you.

You look back on the trade and go “man, that was a great trade, and I ruined it.” Yes, because the market gives you your fears. You’re afraid of giving the profits back, well, it will take that for you.

He has this graph in here, which I love. So you’ll notice in this graph, the stop loss is outside the lower band of expectations, which is represented by a probability distribution. But you can see here is when you tighten your stop, you move the stop into the heart of the distribution. Making it very likely, it’s going to get triggered. This is important to understand.

You need to understand that stops hurt performance. Now we do use initial stops to protect our capital, and whenever possible, which is a lot of the time, rather than using an initial stop will actually use an option or an option structure. So you don’t have to have a stop. This is one of the things people don’t understand about options. Options can prevent you from having to have a stop, Which is awesome. We set a framework to protect our initial capital, but we are very, very reluctant to ever raise our stop. We manage the trade rather than tighten stops. The usage of ongoing stops is one of the biggest reasons, biggest causes of underperformance in your trading. If you don’t believe me just go back and look at it.

We recommend using options to manage your risk, so you don’t need to use this stuff.

For many of you, I probably pushed your buttons. My experience has been I share this with students and they look at the data and are like, I don’t believe it. Or I believe you but I can’t do that. Then they go back and trade like crap, trade like shit. Then say “I can’t make money.” You need to understand your exits are much more important than your entries. Entries are important, but exits are more important, and the usage of stops really hurts your exits. Whenever you can avoid using a stop, that’s what you want to do

Do you use stops? What is the context in which you use them? Are you willing to step back and evaluate your beliefs about stops and see if there’s a better way?

I mentioned options. One of the things that I want to make sure, this is one of the things I really help traders with is being able to use options to manage their positions about it. Remember, I said exits are a lot more important than entries. Everybody thinks of options for entry usage, the value of options is often in the exit, and that can be embedded in an entry if you use an option structure when you enter because then you don’t need that exit or in the transformation of the position as the position unfolds. In either case, options are really useful.

So I encourage you to check it out. We’ve got a number of great workshops coming up. Our book on The 10 Irrefutable Laws of Trading Success will be coming out soon.

Let us know how we can help. God bless. Have a great week. I’ll see you next Tuesday.

~Chuck Whitman