Stop Loss is not always your friend...

[luutzu]

Re: Stop Loss is not always your friend....

What you are missing is how much fun these two guys had. And that one horse could have been an outlier, the results from it don't count

On a serious note, luutzu, a lot of you posts come across as advocating ignorance as a strategy. While many things are unnecessarily complicated, it doesn't make all that is complicated wrong.

No, not ignorance. In-depth knowledge. I'm not a random walk guy.


Anyway, I just enjoy studying businesses...

 

[DeepState]

Re: Stop Loss is not always your friend....

All these reminds me of a story I heard somewhere. It goes something like this:

Two country Gentlemen at a bar were having philosophical debates and somehow it got to them debating how many teeth does a horse in the barn outside have.

One said that horses are of that genus, related to this and that; and this and that have this many teeth... horses being bigger and eat grass and at certain age it have this many teeth;

The other argued that it depends on the origin of the horse in question... Arabian horses would have this many teeth, factor in the climate and this and that, it would have this many teeth at this and that age, depends on age and birth and health blah blah.

They debated back and forth, back and forth into the early hours... still keep going until a lowly, uneducated bartender told them...

The barn's unlocked, why don't you guys just go out there and open the horse's mouth and start counting.



---------

With investing, you don't have a lowly, uneducated bartender telling you... you got at least two self-made multi-billionaire investors telling you to go and open the horse's mouth and start counting. But somehow real, smart, investing just doesn't work like that.

Please count how many teeth there are on this horse and let us know what the answer is oh worldly one.



Hint: The answer might be on YouTube.

 

[KnowThePast]

Re: Stop Loss is not always your friend....

Please count how many teeth there are on this horse and let us know what the answer is oh worldly one.

View attachment 60708

Hint: The answer might be on YouTube.

One of the few times I actually laughed out loud. Very subtle.

 

[luutzu]

Re: Stop Loss is not always your friend....

Please count how many teeth there are on this horse and let us know what the answer is oh worldly one.

View attachment 60708

Hint: The answer might be on YouTube.

See, when you talk too much nonsense you will not be able to know head from tail.

 

[DeepState]

Re: Stop Loss is not always your friend....

KTP

Can you please resubmit the result for the last six months per the attached spreadsheet with internal working so I can understand how you came upon the numbers you have mentioned for the most recent period. I'm not sure how I get from that spreadsheet to the figures you mentioned. It would be good to get aligned with you.

On the binomial tree, it is the simplest toy possible, but it has all the features needed to make this point. However, should you wish a fuller explanation, please refer to the exchange that I had with Artist. Both of you have raised the same, perfectly reasonable, issue. Bottom line, no matter what the distributional properties you select, as long as the average outcome is zero (representing no insight on directional prediction) and the stops are not directionally informed, you can whack stops anywhere you like. It will not change the expected return outcome. It will change the distribution shape.

If you start with the simple binomial tree, the point should become evident. No movement of stops changes expected outcome. No additional complexity will change the outcome.

 

[DeepState]

Re: Stop Loss is not always your friend....

Getting on to risk - do stop losses reduce risk in a highly diversified portfolio? I would expect that they change the shape of losses, but not the final outcome.

If you are talking about individual stock stop losses then a portfolio of these will be affected.

Here's one way of thinking about it.

We are in a fake world where each stock performs independently. Each stock has a normal distribution. There are ten equally weighted stocks. The portfolio will have a normal distribution.

Now, change the stock distributions to something positively skewed. Anything. That is what happens when a stop loss is in place. The same equally weighted portfolio will have a positive skew, though less so than the skew for each individual stock because of diversification effects.

If the stocks become more correlated, the skew of the portfolio increases.

If one of the stocks is massively volatile relative to the rest, the skew of that will dominate and result in a skewed portfolio outcome which is greater than the previous scenarios.

No matter what the correlation is other than it being less than 1, the more stocks you have, the more evenly their risks are distributed, the more normal the portfolio looks whatever the degree of skew you put in place at the individual stock level. In that situation, if the overall portfolio matters most, it is better to hedge this with an option like payoff over the whole portfolio.

 

[KnowThePast]

Re: Stop Loss is not always your friend....

KTP

Can you please resubmit the result for the last six months per the attached spreadsheet with internal working so I can understand how you came upon the numbers you have mentioned for the most recent period. I'm not sure how I get from that spreadsheet to the figures you mentioned. It would be good to get aligned with you.

On the binomial tree, it is the simplest toy possible, but it has all the features needed to make this point. However, should you wish a fuller explanation, please refer to the exchange that I had with Artist. Both of you have raised the same, perfectly reasonable, issue. Bottom line, no matter what the distributional properties you select, as long as the average outcome is zero (representing no insight on directional prediction) and the stops are not directionally informed, you can whack stops anywhere you like. It will not change the expected return outcome. It will change the distribution shape.

If you start with the simple binomial tree, the point should become evident. No movement of stops changes expected outcome. No additional complexity will change the outcome.

Thanks RY.

The point I was trying to make is that market can be irrational for prolonged, perhaps indefinite periods of time. In case of low PE/PB, it seems to persist despite he model saying that it cannot (consistently). Reasons for it can be argued, but data is too consistent for too long to dismiss it.

Could the same be the case with stop loss strategies? Apparently not.

There are two ways to find statistical edges. One is to start with theory, then check the data. Or, find the data, then find a matching theory. Unless data is overwhelmingly consistent, you are never going to know for sure.

The spreadsheet should have everything to reconcile the figures:
- Start point is 11/06/2014, cash of $1,000,000
- Suitable candidates are bought on day 1.
- 1 month per step. Daily would be more accurate, as it will miss stop losses on stocks that have gone below trigger point, than got back up. For the record, I did try it on a daily step, result was about the same.
- Each step, universe is sorted by P/B, lowest to highest.
- Sum of all trades is the overall profit.

I've added worksheets for the run without stop losses, and the universe used. Attached. Thank you very much for taking a look.

View attachment stoplossTrades.xlsx

 

[KnowThePast]

Re: Stop Loss is not always your friend....

If you are talking about individual stock stop losses then a portfolio of these will be affected.

Here's one way of thinking about it.

We are in a fake world where each stock performs independently. Each stock has a normal distribution. There are ten equally weighted stocks. The portfolio will have a normal distribution.

Now, change the stock distributions to something positively skewed. Anything. That is what happens when a stop loss is in place. The same equally weighted portfolio will have a positive skew, though less so than the skew for each individual stock because of diversification effects.

If the stocks become more correlated, the skew of the portfolio increases.

If one of the stocks is massively volatile relative to the rest, the skew of that will dominate and result in a skewed portfolio outcome which is greater than the previous scenarios.

No matter what the correlation is other than it being less than 1, the more stocks you have, the more evenly their risks are distributed, the more normal the portfolio looks whatever the degree of skew you put in place at the individual stock level. In that situation, if the overall portfolio matters most, it is better to hedge this with an option like payoff over the whole portfolio.

Hmm, I think we talked before about Mandelbrot and his criticism of using bell curves for share prices distribution.

What if stop less help to increase or reduce the number of instances of fat tails and outliers?

 

[craft]

Re: Stop Loss is not always your friend....

What if stop less help to increase or reduce the number of instances of fat tails and outliers?

That’s exactly what you will do (but maybe in the reverse of what you are thinking). You have by design an asymmetrical risk/reward. You can lose 0.7 book value – you can win 1.3 (2-0.7) of a ‘growing’ book value. introducing the stop will reduce your 0.7 loses down to ~ 5% of 0.7 but give you many more loses and in the process will also remove your exposure to the stocks that dip and then go on to be 2xbook exits. The stop will also however increase your opportunities (you will churn through many more stocks) – which will give you more chance of picking up something that goes straight on with the job like RDG (if its actually tradable).


RDG (profit $74,847) is only in the stop loss sample. You have it down as purchasing $20,429 on the 11/7

It traded $1,120 on 2/7 and $2,400 on the 16/7 – nothing in-between.
Haven’t checked any further – don’t really need to because with just this one data point the back tests is nothing like reality – so it’s useless trying to draw conclusions from the results.
RY has covered the theory pretty comprehensively.
We should always challenge theories with reality but it needs to be done accurately lest we deceive ourselves.

 

[Joe Blow]

Re: Stop Loss is not always your friend....

Just a note that I have moved this thread to the Stock Market Nuts and Bolts forum, as I feel the discussion is a little too advanced for Beginner's Lounge.

 

[tech/a]

Re: Stop Loss is not always your friend....

We should always challenge theories with reality but it needs to be done accurately lest we deceive ourselves

So in the case of attempting to increase frequency of trading by (I wont call it a stop) exiting when you believe you have it wrong and re entering when you believe your right again.

As in the example in Trembling Hands Example of a session of trading.

The discussion so far appears to be around arresting outlier moves against us.

 

[DeepState]

Re: Stop Loss is not always your friend....

Hmm, I think we talked before about Mandelbrot and his criticism of using bell curves for share prices distribution.

What if stop less help to increase or reduce the number of instances of fat tails and outliers?

Same outcome. Any distribution with mean of zero and stops placed that are not directionally informed will yield the same outcome. Stops do not lift the mean of the distribution. If it did, we would have alchemy (something from nothing in a closed system - alpha is a closed system). Alternatively, if stops destroyed value on average in this set-up, we would destroy matter/energy/money from within a closed system on a net basis. Neither scenario is possible. Brokerage and other costs are leakage from the system in reality or you can otherwise regard it as endogenous as you wish.

For every trade strategy taken, the market, as a whole, did the opposite (in terms of alpha). If you place a stop in one direction, an effective (anti-)stop was placed in another. Placing stops cannot generate value in and of themselves without accurate directional prediction. One wins and one loses. Net zero before expenses. Every time. Any distribution with mean of zero.

 

[DeepState]

Re: Stop Loss is not always your friend....

So in the case of attempting to increase frequency of trading by (I wont call it a stop) exiting when you believe you have it wrong and re entering when you believe your right again.

An important step forward here.

Let's say there is no concept of stops at all. Every position we put on is driven entirely by insight. The stronger the insight, the bigger the position. The weaker the insight, the smaller the position. The insight can lead to a reversal of the direction. Conceptually, you can move from:

Massive Long -> Moderate Long -> Standard Long..... -> Modest Short....-> Massive Short

No stops. All position size changes are insight related. If your insight is derived from price levels and even time in some way, you can plot what your position size would be for the whole forward surface of price/time. You can do this without knowing what the price will actually be (because you can't really know what it will be).

If you have insight, you will generate coin. No stops required. If you do not have insight, you will generate nothing.

This is precisely the way in which 'signals' are converted to return estimates and ultimately to position sizes (even if the steps aren't quite this formal). It is the exact way in which the concept of return is separated from risk management. No move above is the result of risk management (except for the average position size that you determine at the outset).



As this important conceptually breakthrough has been made, let's progress a bit. It doesn't matter where you get your insight from. Your T/A will generate signals. Some of them are price determined. The signal strength changes as price patterns form etc. Others will do fundamentals etc. What happens when you use stops?

Everything else stands as previously stated.

However, in my view, for most real life situations, even in the presence of insight, there is always the possibility that you will take a loss too large to bear. Sticking a stop there makes sense. It doesn't increase your expected return if you have insight. It reduces it. However, you'd be nuts not to have it in place. It is insurance. You insure what you cannot hack. In this way, directionally uninformed stops add value. Not in terms of making money, but in cutting off the tail of unbearable loss.

I think we are very much on the same page now.

 

[craft]

Re: Stop Loss is not always your friend....

So in the case of attempting to increase frequency of trading by (I wont call it a stop) exiting when you believe you have it wrong and re entering when you believe your right again.

Its a while since I was a serious trader - but I do remember that a big driver to profitability was when I started exiting positions when I thought I wasn't right. Its a subtle difference to when 'you have it wrong' the main difference at least with stocks, is that a not right exit will generally be less congested than a 'wrong' exit spot so you get less slippage and more opportunity because not right generally tends to be a shorter hold period then waiting for confirmation of wrong.

On one hand your break even loses could be considered an arbitrary exit that are an expense as per RY theory, but I suspect that at least on the DAX with your time frame they are acting as a crude 'I'm not right' (on the initial momentum) exit. In which case they fall into the directionally informed category.

 

[Ves]

Re: Stop Loss is not always your friend....

Its a subtle difference to when 'you have it wrong' the main difference at least with stocks, is that a not right exit will generally be less congested than a 'wrong' exit spot so you get less slippage and more opportunity because not right generally tends to be a shorter hold period then waiting for confirmation of wrong.

Think this applies a bit to fundamental investing too. Often my intuition picks up on the warning signs earlier, but my rational / thinking function needs more confirmation / logic (both on entries and exits). I'm still playing around the edges with it (mostly still in the latter camp), but I have a feeling the former intuitive "hunch" might have more value than I give it currently. There's a fine line between "I might be wrong but still need proof" and "****, I'm wrong" sometimes.

 

[KnowThePast]

Re: Stop Loss is not always your friend....

That’s exactly what you will do (but maybe in the reverse of what you are thinking). You have by design an asymmetrical risk/reward. You can lose 0.7 book value – you can win 1.3 (2-0.7) of a ‘growing’ book value. introducing the stop will reduce your 0.7 loses down to ~ 5% of 0.7 but give you many more loses and in the process will also remove your exposure to the stocks that dip and then go on to be 2xbook exits. The stop will also however increase your opportunities (you will churn through many more stocks) – which will give you more chance of picking up something that goes straight on with the job like RDG (if its actually tradable).

Thanks craft, that's exactly what I was thinking.

RDG (profit $74,847) is only in the stop loss sample. You have it down as purchasing $20,429 on the 11/7

It traded $1,120 on 2/7 and $2,400 on the 16/7 – nothing in-between.
Haven’t checked any further – don’t really need to because with just this one data point the back tests is nothing like reality – so it’s useless trying to draw conclusions from the results.
RY has covered the theory pretty comprehensively.

RDG was a big outlier, but even after taking it out, there was still an outperformance of over 8%. And as you pointed out, a strategy with stop losses has more chances of picking up an outlier like this. So, it can't be discounted completely.

We should always challenge theories with reality but it needs to be done accurately lest we deceive ourselves

Absolutely. My initial tests did not agree with the theory. No challenge, it's been an absolute pleasure to work through it together with all of you to see what could have been off.

There's been many posts of tremendous quality on this thread, thank you all. While I come away from it with anything I am likely to use, my understanding of the topic has improved vastly.

 

[galumay]

Re: Stop Loss is not always your friend....

Outstanding quality of debate in this thread, a fine example of what really makes ASF such a great site. I wont pretend that I even understand some of the more escoteric and mathematical points of discussion but it sure as hell has been a fascinating read!

 

[burglar]

Re: Stop Loss is not always your friend....

Outstanding quality of debate in this thread, a fine example of what really makes ASF such a great site. I wont pretend that I even understand some of the more escoteric and mathematical points of discussion but it sure as hell has been a fascinating read!

I agree, and the participants were really well behaved!

 

[craft]

Re: Stop Loss is not always your friend....

Think this applies a bit to fundamental investing too. Often my intuition picks up on the warning signs earlier, but my rational / thinking function needs more confirmation / logic (both on entries and exits). I'm still playing around the edges with it (mostly still in the latter camp), but I have a feeling the former intuitive "hunch" might have more value than I give it currently. There's a fine line between "I might be wrong but still need proof" and "****, I'm wrong" sometimes.

Hi Ves, Good to hear from you.

Absolutely applicable to fundamental investing, the earlier your unique (and correct) insight the less your competition, the better your potential entry or exit price. Obvious confirmation will be seen by many and priced into the market relatively efficiently.

In relation to this thread and stops – The type of investing we do is business analyse – we seek to follow positive business performance trends and transact when the value/price differential makes financial sense. Any ‘price only’ based stops or exits or whatever you like to call them can only be arbitrary. For us using them can only be an expense that takes away from our potential business analysis return. They might be an expense you are willing to pay to insure your liquidity or your tolerance to volatility, or losing your analyse edge etc, but they can’t increase the return.

The only way they will increase your return is if our business analysis abilities destroy value in which case the ideal price based stop is your entry price – ie you shouldn’t be investing fundamentally.

 

[craft]

Re: Stop Loss is not always your friend....

I agree, and the participants were really well behaved!

Aw come on burglar - we never misbehave - we're just misunderstood.