Aikido Technical Analysis: Stop-Losses

A stop-loss order is a type of order which closes out a position when the price drops below a certain level. Stop-losses are used in portfolio management to limit risk.

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Index

A stop-loss order is a type of order which closes out a position when the price drops below a certain level. Stop-losses are used in portfolio management to limit risk. Stop losses provide a systematic way of selling off losers and therefore capping losses at a defined level. The logic behind it is that short-term momentum persists and therefore it’s in our best interest to sell off positions before they drop even further. 

Advantages

Overcome Your Inclination to Intervene

Most inventors are aware of the emotional toll of watching their positions fall by a considerable percentage. We’ve written about it before, many times. See this or this blog post on mindful investing and the destructive impact that our emotion plays on our performance. It turns out that panic selling actually does have a purpose, kind of. When we do it in a systematic manner, through the use of stop-losses, we can improve both the return and risk-adjusted return of our portfolio.

Outperform

So much emphasis is placed on the risk-adjusted returns / Sharpe ratio of a given portfolio. This ties into the above point. Humans cannot handle high volatility, which may be associated with high-performing strategies. Remember, the efficient market hypothesis states we must take on additional risk for additional return. While the fundamental thesis of any active investor is inconsistent with this idea, it’s clear there is a very high correlation between risk and return. While a 30% compound return seems attractive on face value, if there’s a 50% associated volatility, it will chew up and spit out the ‘weak hands’ who cannot stomach those swings. Stop-losses to the rescue. Stop-losses allow an investor to systematically exit a position that has short-term underperformance. This reduces drawdowns, volatility, and losses. It increases risk-adjusted metrics and may even increase the nominal or raw returns.

Increased Automation

Don’t be a ticker watcher. Using stop-losses gives us peace of mind that our risk management is in place without the need for us to constantly monitor the performance of our portfolio.

How to Implement a Stop-Loss Order

Let’s assume we want to sell a position for a maximum loss of 20%.

  • Buy stock at a price x.
  • Set a limit sell order at a price that is 20% lower than x.

Example

Joe creates a limit order for 1 share of Microsoft at a price of $100. He attaches a take-profit order which has a limit price 20% higher than the original limit order.

Limit your loss

Joe submits the following orders to his broker – 

Order Type

Action

Limit Price

Limit

Buy

$100

Stop Loss

Sell

$80

Assuming the original limit order is executed for $100, and the price of Apple falls to $80, then Joe’s position will be closed out at a 20% loss. As we can see in the above graph, the price of MSFT continues to fall and therefore Joe has improved his return by employing the stop-loss order.

Trailing Stop-Loss

The stop-loss we explored above is static. What if we want to update the price of the limit-order dynamically? Well, this is where we can use a trailing stop-loss. Let’s recycle the example from above. Joe buys MSFT at $100. The price of MSFT increases to $150. Our static stop-loss was originally set at $80. It has almost no function now. What we would like to happen in this situation is to update the price of the stop-loss order in line with the rising price of MSFT. So when the price of MSFT goes to $150, then we increase the price of the stop-loss order to $120 ($150 – ( $150 * 20%) ). This ensures that no matter what happens to the price of MSFT, our drawdown is capped at 20% and we ensure a portion of our gains.

How to Implement a Trailing Stop-Loss Order

Let’s assume we want to sell a position for a maximum trailing loss of 20%.

  • Buy stock at a price x.
  • Set a limit sell order at a price that is 20% lower than x.
  • Only, if the price of the stock increases, update the price of the stop loss.

 

Limit your Loss 2

The effects of the trailing stop loss should be obvious. It allows us to greatly improve the performance of the portfolio, as we are capping our maximum drawdown ( peak to trough ) on each position to 20%.

In Practice 

Let’s take a look at how the stop loss performs on some of Aikido’s Strategies. We’ll look at its effect on Microcap Momentum, Top Quality and High Momentum, and Superior and Steady Stocks. We’ll try to determine its efficacy as well as determining the best stop-loss percentages to use.





Trailing Stop-Loss | Compound Interest

In all three cases, the trailing stop loss reduced the backtested compound return of the strategies. This is partly due to the fact that we are not always invested 100%. When a stop-loss order is triggered, we are forced to hold cash. Stop-losses are generally utilised to improve the risk profile of the portfolio, rather than to improve the absolute return.

Trailing Stop-Loss | Sharpe ratio

The Sharpe ratio provides more interesting insight into the effectiveness of the trailing-stop-loss add-on. In the case of the Superior and Steady Stocks strategy, every stop-loss we best tested improved the risk-adjusted returns of the strategy. The maximum Sharpe ratio we recorded was 1.291 with a 10% trailing stop loss versus 1.152 without this feature. Overall, it appears that the trailing stop-loss has a positive effect on the risk-adjusted returns of strategies which we’re tested. 

The trailing stop-loss had a predictable outcome

The trailing stop-loss had a predictable outcome on the maximum drawdown of the various portfolios. As the trailing stop-loss percentage decreased, so did the maximum drawdown. Although reducing the maximum drawdown is desirable, it is at the expense of the return. We must find the right balance between the drawdown and the profit provided by the strategy. Too small of a stop-loss percentage will cause our positions to get ‘wicked’ out with even moderate volatility in the underlying stock price. We’ve run a huge number of backtests to determine the optimal stop-loss percentage for each of Aikido’s Strategies. In the coming days, we’ll share our results with you. 

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