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By Paul Dunn

We recommend the use of a stop loss when trading our model. This is frequently a source of questions from our users, as stop losses are considered by many to actually limit returns, not enhance returns. This article describes a simple trading system* that uses a stop loss, and shows how properly used stop losses can limit drawdowns and enhance returns.

First, lets cover how NOT to use a stop loss. The problems we generally see are:

  • Getting out of an open position too quickly; the stop loss is in the noise level of the security being traded.
  • Slow to reinvest, or no actual strategy for when and how to reinvest.
  • No strategy on what to do with cash while not invested.

Here is an example of a poorly executed stop loss strategy: trade SPY (SPDR S&P 500 ETF) using a 5% stop loss (tracking, split and dividend adjusted**), and on the last day of each quarter check the slope of the 250 day moving average and invest when the slope is positive and the account is in cash. (All examples assume an all-or-nothing strategy; the account is either 100% invested, or in cash.)

(Green line - buy-and-hold results for SPY. Red line - return using the strategy described above. The same colors and scale will be used for all charts.)


(Click to enlarge)

The stop loss did limit the drawdown, but also didn't generate much return during the market rallies.

Here is a better example of how to use a stop loss. Again trade SPY, but use a 10% stop loss (tracking, split and dividend adjusted**). On the last day of each quarter check the slope of the 100 day moving average and reinvest when the slope is positive and the account is in cash. (Note that this "better use" is slower to sell, and quicker to reinvest, compared to the "poor use" case above.)

(Green line - buy-and-hold results for SPY. Red line - return using the strategy described above.)


(Click to enlarge)

We're on the right track. Again the drawdown was significantly limited as compared to a buy-and-hold strategy. (The drawdowns were about 25% for our "better strategy", and 56% for buy-and-hold of SPY.) The obvious problem is that we didn't do anything with the cash when we were not invested.

It's tempting to stop there; you've limited the drawdown during the financial crisis, and achieved an average annual return of about 5.4%, compared to an average annual return of about 4.2% for SPY. Wow! You beat the index and limited the drawdown. What could be better?

Well, how about doing something with the cash when not invested? For this next example, let's do just as above, with this exception: uninvested cash is put into SHY (iShares Barclays 1-3 Year Treasury Bond), and before buying, the slope of the 100 day moving average of SPY and SHY are compared and the purchase is made on the ETF with the higher slope.

(Green line - buy-and-hold results for SPY. Red line - return using the strategy described above. Blue line - SHY)


(Click to enlarge)

There are several interesting points to make about this final case.

  • Average annual return is now 7.9%.
  • The biggest drawdown was NOT the 2008 financial crisis, but a 10% stop hit in early 2010.
  • By providing one alternative to SPY, which was very conservative by choosing 1-3 year Treasuries, we increase the overall return substantially.

There were several instances in this data set where the timing, by chance, worked very well in favor of this strategy with these securities. By that we mean that if the reinvestment decisions were moved by only a few days one way or the other, the results changed significantly; generally for the worse, though better than the prior strategy that did not provide an alternative to SPY. When tested across many combinations of funds, we believe that providing one conservative alternative to your target fund provides beneficial results.

To prove that, we also tested this final strategy using SHY in combination with each of the following ETFs: AGG, EEM, EFA, HYG, IJH, IVV, IWF, IWM, IWN, IYY, VOE, VTI, and VYM. In all but 2 of 14 cases, providing SHY as an alternative increased the average annual return.


(Click to enlarge)

It is important to note that in all of the examples above, the investor was assumed to make just 4 purchasing decisions each year, all evaluated on the last day of each quarter. (Selling decisions were made as required by the use of the stops. After hitting a stop, the account was modeled as being in cash.)

Summary

We believe that a stop loss can be an important tool to all investors. Keys to properly using a stop loss are:

  • Having an appropriate stop value given the volatility of the securities you trade.
  • Having a strategy for how and when to reinvest after hitting a stop.
  • providing at least one (conservative) alternative to the security you trade.

* The trading strategy described in this article is a simple approach that anyone can implement using trading tools available on the internet. This does not represent the strategy employed by SimpleAllocation.com in our proprietary model.

** Tracking, split and dividend adjusted stop loss - "Tracking" means that the stop loss tracks upward movements, and applies to the highest price since purchasing the security. "Dividend adjusted" means that you adjust price changes for dividends. The "adjusted price" quoted on many websites is just that, dividend and split adjusted.

Disclaimer - Simple Allocation LLC does not advise the use of this strategy for anyone. Past performance of any trading strategy is not a predictor of future returns. Check with your financial and investment advisors prior to any trading.

Source: ETF Trading Using A Stop Loss - Limit Drawdowns, Maximize Returns