Cutting your losses: Pros and cons

08 March 2018 by National Bank
Men holding dominos

You sometimes hear people saying that it’s not a good idea to incorporate a stop-loss model (SLM) into an active management strategy. The main argument for this position is that it is difficult or even impossible to define a rule or identify a cutting point that works well on a regular basis.

Although this argument is widely recognized as true, we aren’t aware of any successful professional traders who don’t use an SLM. We therefore tend to favour the argument that SLMs have more benefits than drawbacks.

There is no universal recipe that allows you to establish an ideal SLM, as an appropriate SLM must take into account (1) your “entry” model (i.e. how you generate your buy and sell signals) and (2) market conditions (for example, the “ideal” level for the loss limit should be a function of the volatility of the market on which you are trading). It is nevertheless possible to establish an analytical framework that will help you accomplish this.

First underlying concept: 2 – 1 ≠ 0 + 1

Advances in behavioural finance have allowed us to learn a great deal about the psychology of risk-taking. One of the most widely accepted findings is that investors display an emotional bias that makes them hesitant to acknowledge an error and realize (“cash in”) a loss. Experiments conducted demonstrated that most people present a more marked emotional charge when they lose something than when they win. Transposed into the world of active management, this means that most investors will hesitate to acknowledge that they were wrong and will “drag” a losing position along with them for too long, as they do not want to face the reality of realizing a loss. Good professional traders have managed to recognize and overcome this psychological bias.

The best example of this bias is illustrated by an experiment on a group of monkeys that involved first giving a banana to each monkey. As expected, they all liked the gift. Next, after a short wait, the experimenters gave the same monkeys two bananas, but took one away just as the monkey was about to grab it. Invariably, the monkeys looked very unhappy … even though they ended up with a banana in hand, just like in the first part of the experiment. A crucial step in your program to improve your active management strategy consists in showing humility, acknowledging that you will always be exposed to the risk of completing the wrong trade, cutting losses when you think you were wrong … and especially, not regretting cutting a loss if the price of the security that you traded moves in the right direction again.

Second underlying concept: it’s all a matter of statistics

Professional traders are often wrong. Their success stems from the fact that their errors are less costly than what their successes bring in. In other words, they take the steps to implement an SLM so that on average their gains exceed (the absolute value of) their losses. With this kind of “statistical discipline,” you will be able to gradually calibrate your SLM over time based on your active management style and market conditions. In concrete terms, you can measure the improvement in your strategy stemming from your SLM using the following ratio (often called the Omega Ratio; OR), that many professional traders—and their superiors—follow closely:

For example, if your Success Rate (i.e. the percentage of your trades that result in a profit) is 60% (good professional traders on average generate a Success Rate between 55% and 60% in the long term) and your Profitability Ratio is 2 (i.e. your average profit is double the absolute value of your average loss), your OR is 3, which is excellent:

Ratio Omega

It’s easy to calculate your OR: simply keep a log of the outcome of each trade that you complete to calculate your Success Rate as well as the average profits and losses achieved.

Exemple Ratio Omega

The following table shows the possible ORs for various “realistic” active management scenarios:

At the top right, we have the “singles hitters,” those with a very good success rate (67% in the example), but who manage their losses rather badly (Profitability Ratio of 1), so that they wind up with an OR of 2.0, which is still a very respectable showing. At the bottom left, we have the “home run hitters,” who have a low success rate (33% in this example), but have developed a highly effective SLM (Profitability Ratio of 4), so that they have the same OR of 2.0 despite the fact that they are often wrong.

Tableau de Ratios Omega pour différents scénarios

In summary, although there is no total agreement on the subject, what we see with professional traders lends credence to putting in place a stop-loss model. There is no magic recipe to determine what your SLM should be, as it depends on your active management style and market conditions. However, there are guides, such as the Omega Ratio (or another similar statistical measurement), which allow you to gauge your progress. Next, a great deal of trial and error and a healthy dose of patience will allow you to determine the SLM that’s best for you and calibrate it to suit your needs.

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