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Thomas Bulkowski’s successful investment activities allowed him to retire at age 36. He is an internationally known author and trader with 30+ years of stock market experience and widely regarded as a leading expert on chart patterns. He may be reached at

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Bulkowski’s Can Stops Hurt?

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As of 04/27/2017
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Written by and copyright © 2005-2017 by Thomas N. Bulkowski. All rights reserved. Disclaimer: You alone are responsible for your investment decisions. See Privacy/Disclaimer for more information.

My book, Trading BasicsTrading Basics: Evolution of a Trader book. pictured on the left, has an entire chapter dedicated to stops. It's called, "Do Stops Work?" and it covers ten types of stops, including those I use.

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This article discusses whether or not stop loss orders can hurt trading performance. For the novice trader or investor, the answer might surprise you.

The following replicates tests discussed by Howard Bandy in his Active Trader magazine article titled, "Scaling in as an entry technique," from the October 2009 issue.

Summary

Using a trailing stop loss order based on a percentage down from the current high price means doing worse than buy and hold. Those stops force an exit from the most profitable trades before they can add to profits.

Methodology

I used a database of 571 stocks from 12/31/2003 to 11/3/2008. The ranges were selected so that the software would cover Bandy's testing period from January 2004 to October 2008. During that period, the S&P 500 index dropped 142 points from start to end, or about 13%, climbed 450 points (41%, start to high), and then tumbled 663 points (42%, high to low).

Each test begins with $10,000 in cash and it buys into each stock on the first trading day of each month and exits on the last trading day of the month, at the closing price of each, respectively. Profits and losses are held separately from the initial cash amount, so that the portfolio value doesn't change. In other words, only $10,000 was used per trade, not $10k then $11k then $12k as profits climbed. I tracked the number of trades (58 per stock unless they did not cover the entire date range) and profits to find the average profit or loss per trade.

The initial stop price was based on the current close. Each day after entry, the stop was recalculated using the high price for that day and trailed upward, never lowered. A 5% stop loss meant the stop was set at 5% below the initial close and then trailed 5% below the highest high, whichever was higher, until being stopped out or reaching the end of the month.

Exit occurred if the low price hit or dropped below the stop price. If this happened by the stock gapping open lower, then the opening price was used instead of the stop price as the exit price.

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Results

Picture of stop results

The above chart shows the profit or loss from the system.

Each red line increases in one percentage point increments from 1% to 60% and then jumps to 100%, which means buy-and-hold. Along the vertical axis is the average amount of money made or lost per trade.

The first red line represents a 1% stop loss. Often this triggered the day after placing the trade. It shows a small average profit per trade.

When the stop increases to 3%, profits turn to losses and continue to increase until reaching the 8% stop loss value. After that, a stop loss order sees smaller losses until reaching 36% when a profit emerges. From there, the profits grow for stop loss values up to 60% (the second to last bar on the right). The last bar is for buy and hold, which corresponds to a 100% stop loss value.

If you do not use a stop loss order to exit the position and just sell at the end of the month, you make the most money, about $15 per trade.

Look what happens when you use a trailing stop! If you place a trailing stop closer than 36% below the current high price, you'll lose money. The closer the stop is to the current high, the more money you lose (from 36% to 8%, anyway).

Why? The stop takes you out of the most profitable trades. If you use trailing stop loss orders based on the percentage down from the high price and trade often enough, you'll do worse than if you just buy and hold the position.

-- Thomas Bulkowski

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Written by and copyright © 2005-2017 by Thomas N. Bulkowski. All rights reserved. Disclaimer: You alone are responsible for your investment decisions. See Privacy/Disclaimer for more information. Never put off till tomorrow what you can avoid doing altogether.