In previous articles, we highlighted that simple adaptations to a strategy can have a huge impact on the performance of the strategy, its expected rate of return, and risk profile. We’ve seen that entering and exiting the trade on the same day’s close rather than the next day’s open can boost the strategy’s performance while reducing the risk significantly. Furthermore, the stock universe you want to apply the strategy should be chosen carefully.

The articles we refer to are these:

In today’s analysis, we want to find out whether having a stop-loss helps limit drawdowns.

Stop-loss types

A stop-loss usually is one of these three types:

Exit directly when the stop-loss price is reached

As soon as a certain stop-loss level is reached, e.g., 5% below the entry price, the trade is exited automatically.

Exit on the next day open after the stop-loss price was reached

As soon as a certain stop-loss level is reached, the position is closed at the next day open. Thus the trader expects a certain overnight rebound.

Exit after a certain amount of time on the next day open when the sell signal was not triggered yet

Sometimes the trader is stuck in positions that keep on crashing. The implemented sell signal, e.g. if the close price of the current day is higher than the previous day, is not triggered and the trader gets nervous, the loss of this position increases from day to day. In such scenarios, some traders can sleep better knowing the trade will be exited automatically after e.g. five days. But does that really help the overall performance?

The strategy explained – trading rules

We’re using the same strategy as we have in previous examples:

Trading Rules

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Buy rules:

The stock needs to be part of S&P 500 index
2-day RSI crosses below 10
Stock price trading above 52-week moving average
Entry on the next day open

Sell rules:

If the 2-day RSI crosses above 60, we sell the position on the next day open

Stop-loss variation:

Sell immediately at a stop-loss level of
- 5% below the entry price
- 10% below the entry price
Sell on the next day open if the stop-loss level is reached
Sell on the next day open after five days

Backtest settings:

Time range: 2000-2022
Data provider: Norgate Premium, free of survivorship-bias
Commissions per trade: $0

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Strategy backtest and comparison of the different stop loss methods

Our base strategy is entering and closing the trades on the next day open after the buy or sell signal is triggered and a stop-loss is not applied. Considering all trades from 2000 to 2022, an average profit and loss of 0.41 % was achieved while being invested for 5.75 days (on average for each trade). The win rate is 67.6 %, with an average profit of 2.06% for the winners (which is quite solid).

To calm the nerves, some traders want to have a fixed stop-loss in place to limit the loss per trade. For research purposes, we set the maximum stop loss to -5% and -10%.

However, the -5% or -10%, respectively, can not be taken for granted since a stock can lose a lot more overnight – a fixed stop-loss cannot account for overnight gap downs!

With a stop-loss of -5% in place, the average profit and loss is almost cut in half to 0.22%, the average days held per trade is slightly decreased to 4.71, and the percentage of winners is lower compared to the base strategy. The metrics get slightly better if we increase the trader’s tolerance from -5% to -10%. However, they are still not comparable to the base strategy (see table below).

Another option is to sell the positions at the next day open after the stop-loss level is reached. The metrics are way better for both levels, -5% and -10%, than when selling immediately. This indicates that the stock prices bounce back overnight, and the trader can exit the positions at a better price than the day before.

Especially for the -10% limit, one should check again if this can be a viable solution when trading a portfolio of stocks, limiting the maximum positions to, let’s say, ten at the same time. The percentage of winners is almost the same, with 67.5 % compared to 67.6 % for the base strategy. The number of days the trader holds the position is decreased, which is always good since time in the market exposes you to a certain risk.

The last option we want to check in this article is selling after a certain number of days, in our case, after 5 days. This should prevent the trader from being in positions that keep on falling without any sign of a rebound. Yet again, the average profit and loss is not near the base strategy. The percentage of winners is still decent, and the average number of days held has also decreased significantly.

This table summarizes our main findings:

	No stop-loss (base)	Sell immediately (-5%)	Sell immediately (-10%)	Sell on next day open (-5%)	Sell on next day open (-10%)	Sell after 5 days
Avg. PnL [%]	0.41	0.22	0.31	0.33	0.38	0.34
Avg. days held [-]	5.75	4.71	5.46	4.90	5.51	4.3
Winners [%]	67.6	65.2	67.3	66.5	67.5	66.0

Conclusion

Some traders want to limit the losses of the trading strategy by applying a stop-loss.

This analysis showed that it is not as easy as it seems. We do not have any stop-losses in our mean reversion systems, which sometimes can be nerve-wrecking, but we prefer to diversify into different time frames, assets, and market directions.

Having a good understanding of how the system behaves and why it’s having problems in certain market regimes helps to overcome volatile times. If you want to apply a stop-loss to your systems, we would definitely prefer the exit on the next day open, maybe together with a fixed time stop. If it helps boost the metrics of your system or calm your nerves, or both, it needs to be checked on a portfolio level.

Disclaimer

Quantified Strategies (SIA Lofjord) is not an investment advisor. The content and information provided are educational and should not be treated as financial advisory services or investment advice. Trading and investment in securities involve substantial risk of loss and is not recommended for anyone that is not a trained trader or investor – it shall be conducted at your own risk. It is recommended that you never risk more than you are willing to lose. Leverage can lead to substantial losses. Any use of leverage, margin, or shorting is at your discretion. Quantified Strategies (SIA Lofjord) is not responsible for any losses that occur as a result of its content and information.

Hypothetical or simulated performance results have certain limitations. Unlike an actual performance record, simulated results do not represent actual trading. Also, Since the trades have not been executed, the results may have under or overcompensated for the impact, if any, of certain market factors, such as lack of liquidity. Simulated trading programs, in general, are also subject to the fact that they are designed with the benefit of hindsight. No representations are made that any account will or is likely to achieve profit or losses similar to those shown.

FAQ:

What is the impact of simple adaptations on a trading strategy’s performance?

Simple adaptations, such as entering and exiting trades on the same day’s close, can significantly impact a strategy’s performance by boosting returns and reducing risk. Careful selection of the stock universe is also crucial for optimal strategy application.

How does the performance of the base strategy?

The base strategy, with no stop-loss, achieved an average profit and loss of 0.41%. Introducing stop-loss levels at -5% and -10% reduced the average profit and loss, indicating the impact of fixed stop-losses on overall performance.

How does implementing a stop-loss impact drawdowns in a trading strategy?

Implementing a stop-loss in a trading strategy can help limit drawdowns. Various stop-loss types, such as exiting immediately, exiting on the next day open, or after a certain time, influence the strategy’s overall performance and risk profile.