A stop-loss order protects profit or limits risk on an investor’s open position by exiting at a predetermined price. Placing an order to sell a long stock position if the price drops 5% below the purchase price is an example of a stop-loss order.
In this post, we will dig into what a stop loss is, the different types of stop-losses, understand what a trailing stop-loss is, and analyze the best stop-loss strategy for the S&P 500, ETFs, and equities. I’ll also provide code using Backtrader with data supplied by Intrinio for those interested in trying it out themselves.
You can follow along with the code at the Analyzing Alpha Github.
How Does A Stop-Loss Order Work?
After a trader opens a long or short position by placing an order with their broker, they will often add a follow-up stop-loss order to limit the amount of money they can lose if the investment moves against them. This order stays open until it reaches the stop price, and at that point, the order becomes a market order and executes.
Because it’s a market order, there is no guarantee that the order will execute at the stop price due to slippage. Unexpected news or market conditions can result in a stop-loss order completing at a dramatically different price than the stop price.
A stop-limit order, which executes as a limit instead of a market order, can help alleviate this problem with one significant risk — the order may never execute if the limit price is not hit, causing substantial losses.
Stop-Loss Benefits & Drawbacks
Stop-losses provide many benefits and one big drawback: Automatic execution ensures a trader is limiting their losses to a predefined level, preventing loss aversion. Placing the stop-loss orders in advance with the broker enables a trader to step away from monitoring the markets.
A stop-loss has one primary risk — volatility causing you to hit your stop price too frequently, eroding your capital due to fees and slippage. We’ll look at the optimal stop-loss placement below.
How do Traders use Stop-Losses?
Traders usually place stop-losses on every trade using one of two strategies:
- The exit method for every trade
- The worst-case scenario
While stop-loss orders help to minimize losses, they can also protect gains. Trailing stop-loss orders can help provide profit protection.
What Is A Trailing Stop-Loss Order?
Trailing Stop Orders follow the price and can help protect profits while providing downside protection. With a Trailing Stop Order, you do not have to adjust for price changes regularly.
Trailing Stop Example
Stock A is trading at $100. We place a 5% trailing stop order with our broker. The stop price would be 95% of our high price, or $95. The next day the stock trades to $120. Our stop would automatically adjust to $114. The following day, the stock drops to $114, hitting our stop, and our broker places a market order where our fill price due to slippage is 113. We made $13 on this trade as we purchased the stock at $100 and sold it automatically through a trailing stop order at $113.
The Best Stop-Loss Strategy
Now that we’ve covered the basics let’s dig into the best stop-loss strategy for the S&P 500 index, ETFs, and the S&P 500 constituents. The backtests will use the ten years starting in 2010 and ending in 2019. Unless stated otherwise, all charts will use the 5% stop loss.
S&P 500 Stop-Loss
The strategy attempts to buy the S&P 500 index “SPY” with all of the available cash on the first trading day of every month. The strategy sells the S&P 500 with a stop-loss and a trailing stop-loss of 5%, 10% 15%, 20%, 25%, and 30%, respectively.
| Stop-Loss | P&L | Max Drawdown |
|---|---|---|
| 30% | $24,162.86 | 19.31% |
| 25% | $24,162.86 | 19.31% |
| 20% | $24,162.86 | 19.31% |
| 15% | $24,162.86 | 19.31% |
| 10% | $22,884.81 | 19.27% |
| 5% | $20,624.82 | 20.46% |
| Trailing Stop | P&L | Max Drawdown |
|---|---|---|
| 30% | $24,162.86 | 19.31% |
| 25% | $24,162.86 | 19.31% |
| 15% | $22,072.50 | 21.18% |
| 20% | $21,075.84 | 21.59% |
| 10% | $19,856.82 | 19.45% |
| 5% | $17,044.78 | 21.15% |
The verdict? It appears that the trailing stop-loss performs worse than the stop-loss. Being in the market seems to be the most critical factor for performance in this backtest. The results make sense as economic growth and prosperity are on an upward trend most of the time. Also, the risk of SPY going to zero is much less than with instruments that aren’t as broad. In other words, if SPY goes to zero, it’s unlikely your primary concern at that point would be if a stop-loss or trailing stop-loss performs better!
Sector Stop-Loss
The sector ETF stop-loss strategy works similarly to the above strategy, but it rebalances the 11 stock sectors equally each month.
| Stop-Loss | P&L | Max Drawdown |
|---|---|---|
| 30% | $21,049.11 | 18.33% |
| 15% | $19,168.06 | 16.97% |
| 25% | $18,802.67 | 17.88% |
| 20% | $18,483.95 | 17.68% |
| 10% | $17,440.95 | 16.54% |
| 5% | $14,504.79 | 13.86% |
| railing Stop | P&L | Max Drawdown |
|---|---|---|
| 30% | $20,952.05 | 18.37% |
| 25% | $18,796.26 | 19.16% |
| 20% | $18,740.62 | 17.25% |
| 15% | $16,493.28 | 18.19% |
| 10% | $15,738.22 | 16.04% |
| 5% | $10,319.47 | 12.92% |
It appears that staying in the market is still the number one most important factor for our strategies. This also holds for rebalancing weekly.
| Stop-Loss | P&L | Max Drawdown |
|---|---|---|
| 30% | $20,384.90 | 18.62% |
| 20% | $18,274.58 | 19.28% |
| 25% | $18,234.53 | 18.19% |
| 15% | $17,216.66 | 18.39% |
| 5% | $15,780.16 | 17.31% |
| 10% | $15,060.64 | 20.02% |
| Trailing Stop | P&L | Max Drawdown |
|---|---|---|
| 30% | $19,557.38 | 18.56% |
| 25% | $18,456.04 | 19.32% |
| 20% | $17,570.68 | 18.66% |
| 15% | $17,530.90 | 18.31% |
| 5% | $13,528.47 | 18.64% |
| 10% | $13,006.74 | 21.48% |
Equities Stop-Loss
Next up, we’ll try something a little different. We’ll momentum rank the top 20 S&P 500 companies. This strategy will use the same approach as in the sector momentum backtest.
To get a baseline, I’ve cheated and set a 95% stop-loss as a proxy for no stop-loss:
| Stop-Loss | P&L | Max Drawdown |
|---|---|---|
| 95% | $37,437.90 | 21.85% |
| Stop-Loss | P&L | Max Drawdown |
|---|---|---|
| 30% | $36,142.71 | 23.05% |
| 25% | $35,196.80 | 23.75% |
| 20% | $33,876.70 | 23.47% |
| 15% | $30,923.37 | 24.81% |
| 10% | $23,314.05 | 24.26% |
| 5% | $17,284.30 | 18.31% |
| Trailing Stop | P&L | Max Drawdown |
|---|---|---|
| 30% | $35,432.78 | 23.27% |
| 25% | $31,399.61 | 24.79% |
| 20% | $27,693.02 | 24.17% |
| 15% | $23,534.35 | 25.68% |
| 10% | $14,292.92 | 23.95% |
| 5% | $7,180.54 | 14.28% |
Average true range, or ATR, is often used as a stop-loss for individual equities. In short, a company whose price moves a lot will have a larger average true range than a company whose price is less volatile. The rationale for using an average true range instead of a fixed amount is that each stop should be tailored to how volatile the individual asset is. For example, we would not want to set a 1% stop loss on a security whose price moves 2% daily. Graphs below are displayed using an ATR of 1.
| ATR Stop-Loss | P&L | Max Drawdown |
|---|---|---|
| 5 | $26,591.54 | 26.63% |
| 4 | $24,294.87 | 24.84% |
| 3 | $21,899.09 | 22.39% |
| 2 | $19,431.51 | 20.02% |
| 1 | $14,759.75 | 16.23% |
| ATR Trailing Stop | P&L | Max Drawdown |
|---|---|---|
| 5 | $21,126.80 | 24.07% |
| 4 | $15,108.04 | 22.50% |
| 3 | $10,254.67 | 19.18% |
| 2 | $8,599.62 | 16.27% |
| 1 | $3,175.04 | 10.97% |
The Bottom Line
This analysis shows how important it is to be in the market. Setting your stop loss too narrowly can lead to significant underperformance. An excellent next step would be to test stop-loss strategies for individual market anomalies.
