The impact of stop losses on short-term countertrend trading strategies

ABSTRACT Stop losses are a common form of risk control for trading strategies, but there is a lack of empirical research regarding their effectiveness. Stop losses alter the statistical characteristics of a trading strategy, which makes it difficult to assess the tradeoff between improved risk control and return degradation. To evaluate a stop loss method equitably a systematic and quantitative approach is needed. This paper uses Ralph Vince's optimal fixed fractional position sizing combined with maximum drawdown to normalize the risk and return characteristics of a trading strategy. This risk and return normalization is then used to assess the effectiveness of stop losses as a risk control method for two short-term countertrend trading strategies. Specifically, a range of fixed percentage stops and a range of volatility scaled stops were evaluated. It was found that, due to the distinctive return path of short-term countertrend trades, stop losses were ineffective as a risk control system for these types of models.