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The Best Stop Loss Strategy (Backtested)
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Dec 11, 2024
Learn what a stop loss is and where to optimally place your stop loss. I backtest using ten years of data on the SPY, Sector ETFs, and S&P500 constituents to determine best stop loss placement. ✉️ Learn the secrets of legendary traders and investors: https://bit.ly/4aCna7i 🔗 Follow along: https://analyzingalpha.com/blog/stop-loss-for-stocks 0:00 Introduction 0:37 What is a stop loss? 0:57 How does a stop loss order work? 1:45 Stop loss benefits & drawbacks 2:34 Stop losses to protect profits 3:58 Backtest results 4:20 S&P 500 results 6:12 Sector stop loss results 6:41 Equity stop loss results 7:10 Equity atr stop loss results 7:23 Backtest summary 9:43 Optimal stop loss
View Video Transcript
0:00
hey there leo here have you ever
0:02
wondered what the best stop-loss is to
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use while trading well today you're
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going to find out and like everything on
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analyzing alpha it's going to be backed
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by data so what are we going to talk
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about today well first we're going to
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cover what a stop loss is obviously
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newer traders need to know that then
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we're going to talk about how traders
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use stop losses and trailing stop losses
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then we're going to talk about the back
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test first we back test it on the spy or
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the the index itself then the sector
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etfs and then equities as a whole and
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finally we're going to come to the
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conclusion that you're probably waiting
0:33
for what's the best stop loss to use if
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you're an experienced trader that
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doesn't care to learn about stop losses
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you can skip to minute four for the back
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test results i hope you're excited i am
0:42
let's get rolling so what is a stop loss
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a stop loss order protects profit or
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limits risk on an investor's open
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position by exiting at a predetermined
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price now for those of you that might
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criticize that definition obviously i
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understand that risk you know can be
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quantified in many different ways but
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i'm trying to keep things simple for
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this explanation so how does a stop-loss
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order work well after a trader opens a
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long or short position by placing an
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order with a broker they'll often place
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a follow-up stop loss order that will
1:14
limit the amount of money that they can
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lose on the investment if it moves
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against them now this order stays open
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until it reaches the stock price and at
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that point it executes and because it
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executes as a market order there's no
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guarantee that the order will execute at
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the stop price due to slippage and
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typically if the stops are placed at
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obvious points or there's unexpected
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news the price can actually dramatically
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differ from the stock price now a stop
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limit order which executes as a limit
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instead of a market order can help
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alleviate this problem with one
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significant risk the order may never
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execute if the price isn't hit causing
1:49
substantial losses so what are some of
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the benefits and drawbacks of using a
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stop loss well stop losses provide us
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with many benefits and one big drawback
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automatic execution enables us as
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traders to limit our losses to a
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predefined level obviously slippage and
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overnight moves aside and this prevents
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loss aversion so placing a stop-loss
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order in advance with a broker also
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enables us to step away from monitoring
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the markets and maybe even enjoy life
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even though i know how much we all
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secretly love trading now a stop-loss
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has one primary risk and this is
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volatility causing you to hit your
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stop-loss too frequently and this will
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erode your capital due to fees and
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slippage
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and even though we've been talking about
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stop losses primarily in the context of
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conserving our capital there's also
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another way to use stop losses and that
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is to protect gains
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there are multiple ways to protect
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profits using stop losses but for now
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let's just concern ourselves with the
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trailing stop loss and the reason for
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that is i'm trying to give newer traders
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an understanding of all the options
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available to them so what is a trailing
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stop loss well it's in the name a
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trailing stop loss simply is just like a
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stop-loss only it trails the price and
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this is best seen using an example so
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let's pretend we purchase a stock at a
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hundred dollars and we set a stop loss
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of five percent which would be ninety
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five so right there's five dollars
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because five percent of a hundred is
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five dollars which you know hundred
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minus five is ninety five now let's
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pretend that the very next day the stock
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moves to 120 well the stop is going to
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follow that the stop it would still be
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95 of 120 which would be 114
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right and then let's pretend the very
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next day the price comes back down and
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hits the stop price of 114 and there's a
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dollar of slippage that means that our
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stock would have sold at 113 so what
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happened there so we purchased a stock
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for a hundred dollars it moved up and
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then it came back down hit our stop and
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we made 13 and guess how many times we
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had to update that stop loss zero right
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because it's automatic and it follows
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the price
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and now it's the time you've been
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patiently waiting for or maybe not so
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patiently if you went ahead and skipped
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right to this section
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but we're going to go ahead and review
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those back tests we start in 2010 and we
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run the back test for a 10-year period
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we'll first cover the s p 500 then the
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sector etfs and then stocks and we'll
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notice that
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well i don't want to spoil the surprise
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let's go ahead and check out the s p 500
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back test
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behind me you'll see a graph from
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backtrader which is a popular python
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back testing library if you're
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interested in data science artificial
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intelligence algorithmic trading or back
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testing you can check out my other
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channel here if you're not a coder and
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just want the results don't worry i've
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got you covered now this graph is broken
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into four sections the top section is
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the portfolio section where we can see
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the total value of our portfolio in blue
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and the value of cash in red and we can
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see that that value of cash vacillates
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between 100 invested and 100 in cash
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depending upon if our stop loss is hit
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and if it is hit we then go ahead and
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reinvest next week
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now the second section shows our
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round-trip trades profitability we see
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that the blue trades are profitable
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trades the red trades are unprofitable
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trades and depending upon how far they
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are from the zero line shows the
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magnitude of the profit or loss
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the third section which is arguably the
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most important shows our performance
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against the benchmark our strategy's
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return is in red and the benchmark
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return of just buy and hold is in blue
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and then finally the bottom section
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you'll see the s p 500 with the blue
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dots or the green dots showing
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where we entered and the red dots
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showing where we exited
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at this point i'm going to step out of
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the way so you can see the graphs in
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their entirety as we review them but
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don't worry my magical voice will be
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with you every step of the way i think i
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said step a few times there anyways
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let's check them out i forgot to mention
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that i ran a test for 5 10 15 20 25 and
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30 stop loss levels i'm only going to
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show you the five percent stop levels
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but at the end of this video i'll show
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you the data for everything but i think
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the picture will become clear so as
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we've already discussed the first graph
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is the s p 500 index where our strategy
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underperforms just buy and hold so again
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the stop loss performs worse than just
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holding the next section
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i removed the graph of the s p 500 index
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so it's a little more easier to see and
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we can see that the sector stop loss
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underperformed the buy and hold and we
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can also then go to a trailing stop
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and we'll see that that even
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underperforms even more significantly
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with you know the s p 500 index going up
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2.2
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and our buy and hold only returning uh
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you know 1.03 and for equities it's much
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of the same story we do seem that there
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is some relative positive performance
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but for the most part we underperform
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and with a trailing stop loss that gets
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much more significant so again
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the stop loss strategies have not worked
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so what about if we adjust these stop
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losses to an average true range so that
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way we're not just setting a single five
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percent stop for every stock we're
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actually adjusting it based on the
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average range of that stock well the atr
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stop loss actually performs worse than
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the five percent stop loss and the
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trailing stop loss is actually become
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really terrible now this is the point
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where it's going to show you the data
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but i think the charts that we just went
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over
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that made the message crystal clear but
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if you're interested in the data or the
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code feel free to check out the link in
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the description below where you can see
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everything in its entirety so what did
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we see well we saw that a buy and hold
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strategy beats an arbitrary stop loss of
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multiple levels at the s p 500 index
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level at the etf level and even the
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individual equity level and if we had a
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trailing stop loss basically our
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performance was even worse it was
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miserable now let's take a step back and
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think about why that is the case right
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because in trading everything should
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make sense whether it's a pattern
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whether it's a strategy whatever it
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should make sense and it always does if
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you're on to the right thing so let's
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step back and think about what the
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market is from a trading perspective i
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view the market as this beautifully
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complex game where there's lots of
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really smart participants trying to
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figure out how to be better in fact just
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people like you guys are researching
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this now now if we could set a arbitrary
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5 10 15 20 stop loss or trailing stop
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loss and make money what's going to
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happen well obviously that's going to
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get arbitraged away because you guys are
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going to find it we're going to start
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using it and now it no longer works so
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what is the answer to where you should
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place your stop loss well
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i'm not going to get into market
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structure and why setups work or
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different types of setups work and the
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psychology behind them and things like
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that and different places where stop
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losses are and how they trigger and
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that's why patterns work but blah blah
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blah blah blah basically let's just
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assume a breakout strategy works and
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we've identified a breakout now if we if
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we have a breakout where should the stop
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loss be well it should be at the low
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where it invalidates that breakout now
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there's different areas to place it such
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as the average
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daily range or something like that but
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basically the idea is if it comes back
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down on you it wasn't a valid breakout
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you misidentified that and you should
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stop out now this obviously is different
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for mean reversion trades where you know
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you're essentially catching a falling
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knife this stop loss if you even set one
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is even different
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and finally it also depends on the
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market that you're using right the
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crypto market is a lot more volatile and
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you'll see that it has a lot more
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flushes and
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essentially reclaims
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if you go and look at some of the crypto
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bars you'll see massive drawdowns and
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then they come right back up so the
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stop-loss strategy has to be different
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based on the market so there's your
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answer now if anyone just says oh well
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you should just automatically cut any
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loss at five percent you should probably
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be skeptical now knowing that that just
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doesn't make sense but if someone does
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come to you and says you know what this
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is a market structure this is why it
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works and here's the sound rationale
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behind it then maybe you should listen
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so like this video please hit the thumbs
10:04
up and maybe even subscribe it lets the
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google algorithm know that this is a
10:08
video we're sharing and if you really
10:10
liked it let me know what else you would
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like to see again i love back testing
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and doing all sorts of nerdy stuff as
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you can see on my other channel but the
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goal is to help you guys understand what
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is true in trading because there's so
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much snake oil out there and hopefully
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you know we can make some money together
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i don't know if i can say that this is
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for educational purposes only just so
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you know okay have a wonderful day and
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hopefully see in the next one bye-bye
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