11 Year Research Study - Which Is Best?
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On this channel I often discuss the importance of stop losses and getting out of losing positions before they turn heavily against you, unlike a buy and hold investor who is not only willing to see his equity curve capitulate, but also willing to tie his capital up for years. The impact of such a passive and arguably ignorant approach can be devastating.
In this video we look at a 75-page research study published at Lund University, showing the performance of a stop loss strategy vs a buy and hold approach.
The study looks to compare varying stop loss percentages, from 5% all the way through to 55%, but before we do that, I want to show you some of my trades which were saved from huge losses by applying a stop loss. Remember, a stop loss is simply an order placed into the market at a certain price, and if breached, your broker will sell your position, saving you from any further loss of capital.
Let’s look at some examples.
A recent memorable trade we took was the popular Uber Technologies company, it delivered a handsome return, and by using a stop loss we were protected from considerable loss.
I took the position on numerous technical and fundamental factors, for instance, you can see on this weekly chart that price broke a downward resistance line just after it consolidated for 12 weeks, this made for a good entry, with a stop loss in the region of 13.5%.
Price grew higher over the following weeks, until the blue mack dee line was seen crossing down, it was within this region aligned to the mack dee crossing, that I raised my stop loss and closed at a price of $50.77, for a profit of 42%, which when annualised equated to 131%.
Notice how price soon lost its momentum and 14 months later it had dropped to just over $22, approximately 60% lower than my exit. The buy and hold investor who may have entered at the same point as me, would have lost 38% on the position and still be tied in after almost 2 years.
Next let’s look at one of my trades which failed quite soon after entry, without allowing me to raise the stop loss to lock in a profit.
This time we have Yeti Holdings, a manufacturer of outdoor products.
I entered on the 14th June 2021 after a period of consolidation and breakout. We placed a stop loss at 7.5% away from the entry point within the consolidation area, but this time we saw price retract straight back down causing the stop loss order to be triggered and realising the 7.5% loss.
These immediate losses are painful and inevitable, although in this example, with the benefit of hindsight, the stop loss kept us from a much larger loss of 53%, not to mention the 12 months of capital being tied up.
Remember also that stop losses work exponentially against us, and this 53% loss would have required more than a 100% to recover, whereas the 7.5% loss realised through the stop loss, would have required a similar 7.5% to recover, a much more achievable task.
There’s equally a possibility of taking a quick loss prior to price continuing its upward move, this is an example of just that. The stock Duke Realty saw price consolidate prior to breaking upwards, a tight stop loss was placed at 5.5% but this was hit two weeks later when price retraced, only to rise back up with an opportunity to close out the position at a profit. Price did perform poorly after that but the opportunity of closing at a profit was already gone.
My strategy is based on the principle that anything can happen after a trade is placed, the key is cutting the losses short with a stop loss and allowing the winners to run. Here is a distribution of my past trades which shows how such an approach looks, lots of small losses and lots of larger winners.
My equity curve by using this principle is seen here and shows how the numbers work in our favour over the longer term, despite what happens on a trade-by-trade basis in the shorter term.
With the practical stop loss examples covered, lets move back to the study results.
Let’s quickly unpick the abstract from the research paper. It states the purpose of comparing traditional and trailing stop loss rules against a classic buy and hold strategy. The study is based on the Stockholm 30 index from 1998 to 2009 and is based on holding periods of 3 months each. The study found that stop loss strategies outperformed a buy hold approach, and even more convincing when compared with risk adjusted returns.
It’s worth pointing out that the placements of stops in the study were based on arbitrary areas according to the percentages specified, I have no doubt the study would have been even more conclusive had the study been based on the market structure, similar to the examples I showed earlier, nonetheless let’s look at the results.
First we have the trailing stop loss results. The trailing stop works by the broker continuously tracking price and raising the stop loss accordingly. Let’s say a 10% stop loss was chosen, the initial stop loss would be placed 10% below the price and constantly raised, staying 10% away from the price until it retraced through it forcing to sell the position. In the study, a new position would not be entered until the next quarter after it had been sold.
Here are the equity profiles of all the trailing stop percentages and a buy and hold approach.
The buy and hold approach is this blue dotted line which can be seen in the key here. The worst performing trailing stop percentage was 5% which was constantly languishing throughout the 11-year trial.
The best performing percentages were seen between 15 and 20%.
This table provides specific results for each percentage used, we can see that a 15% trailing stop loss yielded a total return of 73.91% for the 11-year period whilst the buy and hold only achieved a total 1.29%. The worst performing percentage was seen using a 5% trailing stop, which gave a total negative return of 8%.
Considering that these stops were not based on market structure the results make complete sense, I would expect the 5% to under perform simply due to market volatility, regularly hitting the stop loss. Similarly at the other end of the scale I would expect a 55% stop loss to be too wide, therefore allowing price to fall too far.
Between 15 and 20% seemed to be the optimum approach for a trailing stop, now let’s look at the traditional stop loss strategy.
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The traditional stop loss is placed into the market immediately upon purchasing a position, if we assume a 10% stop loss with a buy point here, we then simply hold the position until the stop loss was hit, if the stop does get hit we sell the position and await for the next quarter to take a new position with the same 10% stop loss. If the stop loss is not hit, we continue to hold the position until the next quarter.
This is how the results looked. Once again the buy and hold approach underperformed, with a total return of 1.29%. The best performance came from a 10% traditional stop with a 57% return, closely followed by the 15% stop with a 53% return.
This time the 5% stop did turn a profit, largely due to the stop not trailing price whilst continuously getting hit by normal market volatility.
Notice how performance diminished in an almost linear fashion as the stop loss percentage increased.
Overall however, a 10 to 15% stop loss gave the best result.
We know that both the trailing stop loss and traditional stop loss approach performed better than buy and hold, but which was the best out of them all?
The winning approach was the 20% trailing stop. To get the result we simply took away the traditional stop returns from the trailing stop returns, and we can see that the 20% trailing stop had a 27% improved performance, in fact it was the better approach from 15% upwards.
In summary, avoid a passive buy and hold approach, avoid a 5% trailing stop which is likely to see you get stopped out through volatility, and instead, look to trail your stops at around 20% below price.
It is worth reminding that the study did not consider any technical analysis when placing the stops, I know from experience that if this study was combined with such analysis the results would have been far better, nonetheless it concludes that buy and hold is less superior in almost all instances.
Once again thanks for watching and if you want to learn my strategy with similar principles seen within this study then why not join our group. Bye for now.
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