Do Stops Work?
I am not a big fan of stop losses, and I have some good reasons for this attitude. It is not just a biased opinion. The fact is that the market rewards traders with strong hands and if you are a timid lamb, then you are fodder for the market sharks.
The key is to not be fearful and Part of the secret is to not have any big positions. Small positions reduce your risk for any one trade. My strategy is to keep 20% of your portfolio in unencumbered cash. The idea is to keep some cash available for unexpected events including put assignments. I sell puts quite often so this is a not an unexpected event. The fact is that every trader will eventually lose on some trades.
Generally the best strategy is to spread the remaining 80% of your cash among the remaining positions. There is no required regimen for the remaining positions. If you have a day job that requires you to be away from the market maybe you can only track 10 positions. For many traders 20 positions is the right number. For me the number of positions is about 40. The right number is the highest number of positions you can reasonably handle given your situation.
Given that you have allocated 20% to reserves, then if you want to have only 10 positions the strategy is to put 8% in each position. If you have 20 positions then the strategy is to allocate 4% of the remaining 80%. Again the idea is that no one trade can hurt your portfolio. If you can handle my level of 40 trades then you would allocate 2% of your remaining 80% of trading cash to each trade.
Position sizes are the key to controlling risk and stop losses are flawed for several reasons. When you put in a stop loss you are not guaranteed you will receive the suggested price. If the price gaps through your stop price you will get a different adverse price.
The bottom line is that, based on the math proofs in my book Optimal Portfolio Modeling published by WileyTrading, there is no net benefit to using a stop loss. The news gets worse. The probability of profit is reduced if you use a stop loss. All of this is based on a theoretical log normal distribution.
Arguably the use of theoretical calculations is suspect. The real market place has fat tails and is otherwise imperfect. To answer that Mr. Larry Connors has done the research. His empirical research shows that after 250,000 trades from a winning system all of the stops reduce profits at levels up to 50%. The bottom line is that stops do not work.
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