Stops, from Steve Ellison

October 9, 2007 |

Wrestling with the question of where to place a stop on a position intended to be held for a day, one approach I took was to start with the probability of being stopped out.  If I wanted, for example, a 10% probability of being stopped out, I could look at the last year's daily lows, express each as a percentage decline from the prior close, and find the 10th percentile of these daily maximum adverse excursions.

In datamining with S&P 500 data from the 1980s and 1990s, I found that the tighter the stop, the better the total return.  Had one decided at the advent of S&P futures trading in 1982 to buy the close each day and sell the close the next day with a stop placed so as to have a 75% probability of stopping out, based on a one-year lookback — resulting in stops as little as 0.1% below the prior close — the theoretical return without considering commissions, slippage, rounding, and gaps down would have been an incredible 7,918% by the end of 2000, versus a 528% return for buy and hold.

Alas, this effect disappeared completely after 2002.  The same strategy would have returned only 14% from the end of 2002 to last Thursday, versus a 64% return for buy and hold.


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