Stop It!: Stop-Loss Results for Bearish Scenarios

In the May 27th blog we looked at different types of common stop-loss strategies and discussed when and how to use them. In the June 13 blog we looked at stop-loss results for bullish scenarios and found that absolute stops on the order of 5-15% fared better most of the time compared with trailing stops and the ratchet stop fared the best overall but sometimes at the expense of a higher drawdown. Although it wasn't noted at the time, the cases with no stop-losses did surprising well with average drawdown. Will this be the case with the shorts? Let's find out.

The Set-Up
The set-up this time was similar to the long scenarios, the exception being that I only used 5 stocks for my short portfolios instead of 10. The reason for this is that I've found that there's far fewer choice candidates on the short side. What I did was to look at three different portfolios of 5 stocks each--one composed of stocks priced between $5- $10, one composed of stocks priced between $10 and $30, and the other of stocks priced between $30 and $100. My simulation consisted of finding stocks breaking to new 250 day lows, which is a good strategy in a bear market. If more than 5 candidates showed up, an extra “ickiness” factor was added as a sorting technique. I ran my simulations at two different times when the market was in a downtrend, from 3/19/02 to 7/24/02, and from 11/01/07 to 3/17/08. (Simulation and account information are summarized at the end of the article.*)

The following stops were used: Trailing stops between 5%-50%, Gain/Loss stops with Gains set at 1000% (literally no stop on the gain side) and losses varying from 5%-25%, a ratchet stop, and finally, no stop at all. The following table shows the results. The first row of each simulation shows the profit or loss over the time period. The second row is the number of stocks traded each of which involves two trades, a sell and a buy. The win/loss percentage is in the third row followed by the maximum portfolio draw-down.



Results summary
As I said before, two scenarios don't make for highly accurate statistics but we can note certain trends. The most interesting and certainly not the most expected result is that the best stop-loss seems to be no stop-loss at all! Not only does it post decent returns, but with the least number of trades, the highest win/loss ratio, and lower drawdowns. I was shocked! The next best stop-loss systems are the 25% loss and the ratchet stop. Although the trailing stops did well in the 2002 cases, they did so at the expense of significantly more trades and larger drawdowns. In the 2007-2008 cases, they underperformed the other strategies except for the low priced stocks.

Comparing Bull & Bear market scenarios
If you compare the June 12th bull market table with the bear market one above, you'll see some interesting differences between trading in these two environments. It's a market maxim that trading in bear markets can be more profitable but it's a riskier endeavor. This is clearly evident in the tables where, in the bull market cases, the maximum profit over all scenarios is 73% and the greatest drawdown is 24% whereas in bear markets, the maximum profit is 191% but the maximum drawdown is a gut-wrenching 60%. (All scenarios are on the order of 3-5 months.) The table below compares the average profits and drawdowns for all the bull and bear scenarios as well as for the no stop-loss case. (Note that the numbers below reflect 50% margin accounts.) It's no wonder many people are adverse to shorting stocks!





Conclusion
I guess the moral of the story is that to get the most bang for your shorting buck, setting no stop-loss is the way to go, but you've got to be able to swallow the draw-downs. If you can't stomach that, don't think about shorting--just stay in cash or cash equivalents and take a long vacation. As in gambling, the real trick is to know when to fold 'em. Hindsight is indeed 20-20, but when should you finally cover your positions? The answer is: When the bear market is over. (Don't hit me!) Look at other indicators, especially the VIX, and if that moves below 20 and stays there for several days, I'd go ahead and cover my positions. But I don't think that time is now or anytime soon.

Now you have the long and the short on stop-losses. Use them...or not!


*Simulation Conditions & Parameters: $9.95 commissions. 2% account interest; 3.5% margin interest. All portfolios were algorithmically selected (meaning that I didn't hand pick them, thank the Lord!) according to set parameters. When a stock hit its stop-loss, it was covered. A new search was run and the stock that came to the top of the list was then selected for shorting. All trades were executed at the market-on-close price. Trade sizes reflected a fixed, equal percentage of the current cash in the account. Profit/loss percentages are the result of using 50% margin on all trades (long and short included).