MONEY MANAGEMENT
Untangling The Web
Stop orders minimize losses, but they can also misfire. Here’s a statistical model applied to the spiders that quantitatively measures the profitability of protective stop orders.
The consensus among market strategists is that traders should always use stop orders with long positions. In fact, sometimes even questioning the absence of protective orders invites criticism; evidently, this is a contentious topic. During my presentation for Technical Analysis of Stocks & Commodities at the 2013 New York Trading Expo, the daytraders attending agreed they often found stop orders somewhat meaningful; they were, however, also quick to acknowledge that these orders can just as easily misfire.
The main reason supporting the use of a backstop is to offset your position before a minor loss turns into a devastating setback. Besides insulating you from further loss, it also offers the psychologically calming effect of knowing that your downside exposure is fixed.
Although the premise for minimizing loss appears to be a sensible strategy, the basis for this recommendation comes from subjective theory, not empirical evidence. Thus, the discussion often skirts around this issue by giving us platitudes such as “never let a small loss turn into a big one.” Rather than accept this at face value, I prefer to construct a statistical model to quantitatively measure the profitability of these protective stop orders.
THE MODEL
Popular investment literature has us cutting our losses before a small loss grows into a painful experience. Nevertheless, for most active traders, would it be more profitable to simply bite the bullet, or apply these defensive orders after taking an opening position? Let’s take a look.
Assumptions: In the 743 trading days studied, I always enter into a long position in the spiders (SPDR S&P 500 ETF Trust) at 9:30 am, along with a stop-sell order below this opening (9:30) price. If the stop-order executes, I take no further action. If, however, I am still holding a long position, I will promptly offset it at 10:30; in the process, I will cancel my protective order.
This analysis is based on the following assumptions:
FIGURE 1: APPLYING DIFFERENT STOP PERCENTAGES. Here you see the frequency of receiving a fill on your stop order after taking a long position at 9:30 am. Note the average stop price and the per-share expense for different percentage stops within these 743 trading days (June 1, 2010–May 13, 2013).
This investigation (June 1, 2010–May 13, 2013) tracks the performance of these protective orders when using various percentage stops below the opening price.