June 20, 2016                 Also available in PDF

(Part 1 of 3)

What is it you want? The money, the entertainment, recognition, or maybe just something to talk about as if you were in the know of worldly events. Just in case it is the money, then you might appreciate what follows since it is all about your long-term portfolio protection.

This is a 3-part series that elaborates on the use of stop losses in stock trading strategies. I think you will be able to benefit from my observations. To skip the text, examine the charts for what they have to say.

From the outside, the "game" is easy. You buy shares of some prospering company, wait for the price to go higher, then sell back at a profit, if so desired. Easy, and yet, from what we can see from all market participants, so difficult. Most trying to play the trading game have a hard time just beating the averages. Not surprisingly, some go as far as failing at it altogether.

The problem does not come from not understanding what to do.

You don't need to explain to anyone the mechanics of a trade for too long. It is not as if there was something esoteric or mysterious in its execution. On our computers, we screen candidates to select a stock and an entry price, press enter, wait for some time (could be a long time), and then press enter again to exit the trade. You can even automate the process and have a machine do it all for you.

The real problem is in the ability to extract lasting profits, and I do put emphasis on lasting profits. It is not in one's ability to extract some profits on a trade here and there. It is over the long term, say over 20 or 30+ years, that the real challenge resides. It requires knowledge, skills, and patience to extract more profits than losses from one's trading activity. This means the accumulated profits generated alpha over the years, thereby exceeding average market returns, hopefully by a wide margin.

A single trade is nothing, especially if it is short-term. Because from there, the immediate question is: what next? What do you do for an encore? With, for a second question: how big was that short-term profit anyway? What bet size was required to achieve it? Can it be duplicated, and how often?

If you are building a retirement portfolio for yourself or managing other people's portfolios, the longevity problem is a major concern. It will be followed by more questions: can you assure me your portfolio will be worth more in 30+ years than today? Will it outperform index averages? Will you really generate positive alpha? You should want answers to these questions now, before undertaking this long journey.

If you consider answering those questions as depending on the outcome of a series of applied random bets, and say: maybe. Then, my suggestion is to stop reading this and stop playing. You are simply gambling your future away with a final probable outcome with nothing substantial to show for it. Might as well quit while you are still ahead and do some good; give away what is left of your portfolio to needy people. Or, buy some low-cost index funds. At least, by doing so, you will end up positive, even if it is most likely just average positive, which is still much better than just preserving one's capital or losing it.

When you lose at this game, you are feeding the rich and those who have learned to play the game. Somehow, the cash you lose will end up in somebody else's hands, and most probably, they are not poor hands since poor people simply cannot afford to play the game.

Take a closer look at long-term winners. What do you see? Short-term traders? No, all you see are long-term traders/investors having mostly a Buy & Hold mentality and can swing trade whenever they find it appropriate, meaning potentially rewarding. At the end of the day, all shares are in someone's hands.

Some don't get the math underneath it all. Like you will often hear: always use a stop loss to protect your capital. But you seldom see any kind of demonstration as to the effectiveness or validity of the saying. Answers to questions like: is it more profitable to have a systematic stop loss in place in your long-term trading strategy? Can your trading strategy really last that long? How many times over a stock's price history can you execute your type of trade? Will your trading strategy fail with time, as so many do? All valid questions, but most often, not answered.

Just yesterday, I read the following conclusion to someone's article on trading. Here is a direct quote:

"No matter what your strategy or when you decide to enter, always remember to use protective stops and you'll be around for the next trade. Capital preservation is always key!"

It is said as part of what I consider trading advice folklore, is widespread and can be seen in financial literature all the time. But, usually, nothing is provided to substantiate the claim.

Sure, on one trade, it appears as common sense: preserve your capital, and it is key. Otherwise, not preserving implies you are losing or going broke. But, what happens when you really apply stops to a trading strategy is not covered, only that you should execute stops. It is not enough.

You should know why you apply stops and what they will do to your long-term portfolio. Otherwise, you are operating in the dark, and if you don't know why you are doing something in this game, then you should not be surprised if the market has more than a few surprises (lessons) in store for you; a lot of them. And not so pleasant since most probably they will cost you.

There are not that many ways to show if a stop-loss trading strategy has value or not. It is easy to demonstrate on a single trade that a stop loss was a good idea. I could show you hundreds of examples where getting out of a trade using a stop was the thing to do. But how about over a long-term trading interval? How about over hundreds of trades? Will the winning trades more than compensate for all the executed stops?

One can test this on long-term historical stock price series and tabulate the results. Doing such a backtest will also reveal the strengths and weaknesses of the programmed trading procedures and show their general behavior over time. But, if you do not do the testing job properly, then what would have been the purpose of having done those tests? You need to build on solid foundations.

There is also this notion that if you don't do the tests, then what could you claim? Wouldn't that advice be just other expressed opinions without corroborating statistical evidence? A backtest can certainly be revealing showing a strategy's idiosyncrasies when put on the table for all to see.

Common sense still needs to prevail.

... to be continued

Created... June 20, 2016,    © Guy R. Fleury. All rights reserved