One of the questions that every quantitative trader must address is whether adding a stop-loss component to their system will help or hinder its performance. I have written a good deal lately about the pros and cons of different types of stops, but haven’t had much actual backtesting data to work with.

When I wrote a post about about Cesar Alvarez’s S&P Rotational Strategy a few weeks ago, I suggested that adding a stop-loss might lower the maximum drawdowns. This would give the strategy a way to exit losing positions during the month, rather than waiting for the monthly redistribution. Theoretically, this would have reduced some of the big losses that the strategy suffered in 2008.

We assume that adding a stop loss component has the quantitative value of a safety net, but that isn’t always the case.

In addition to writing about that idea here, I also commented on Alvarez’s post. In response to that, he has written a follow-up post addressing my suggestion to implement stops:

Continuing from the post, we are adding a maximum stop loss. The stop is evaluated at the close each day with the exit happening at the close.  The tested stops are 5%, 10% and 15%.

Interestingly, Alvarez finds that adding stops can be helpful in some situations and terrible for performance in other situations. While adding stops may always seem like a logical idea in theory, Alvarez shows that actual performance can prove otherwise.

Best Performing Stocks

The version of the best performing stocks strategy that we looked at in the previous post utilized a market timing indicator and a six month look-back period. That strategy produced a CAR of 10.48% with a maximum drawdown of 42.22%. Here are the numbers when 5, 10, and 15 percent stops were added:

• 5% Stop: 10.51% CAR, 26.30% MDD
• 10% Stop: 10.85% CAR, 38.05% MDD
• 15% Stop: 10.84% CAR, 39.48% MDD

As you can see, adding the stop loss doesn’t do much for the CAR, but it does a great job of reducing the maximum drawdown. When the stops were applied to the version of the strategy with a 12 month look-back period, the impact on maximum drawdown was similar, but the CAR saw a bit more of an increase. When the stops were applied to each of the two versions without the market timing indicator, we saw a slightly less impact on drawdown and a much greater impact on CAR.

Alvarez also commented that in almost all cases, the 5% stop was the best performer, which he thought was unusual:

Normally close stops tend to be the worst but the 5% stop tends to be the best.

Worst Performing Stocks

The worst performing stocks version of the strategy that we looked at used the market timing indicator and a six month look-back period. The strategy without stops had a CAR of 13.05% and a maximum drawdown of 27.88%. Here are what the numbers look like when the different levels of stops were applied:

• 5% Stop: 5.11% CAR, 28.26% MDD
• 10% Stop: 8.36 CAR, 30.90% MDD
• 15% Stop: 10.47% CAR, 30.87% MDD

In this case, adding the stops has really hurt the strategy. While there was some improvement in the maximum drawdowns of some of the versions, adding stops basically crippled the CAR of all of the worst performing stocks strategies.

Alvarez notes that this is the result he expected:

For the worst N-month ranking, stops appear to hurt the all results. These results support previous research that stops on short-term mean reversion hurt results.