Stop Loss, Profits Cap, Survivorship Bias, In Addition To Dark Swans

I accept long espoused the sentiment that nosotros should non impose stop-losses on mean-reverting strategies, nor profits caps on momentum strategies. My sentiment on the latter has non changed, but it has evolved on the former.

My master copy argue for opposing stop-losses on mean-reverting strategy is this. Say yous believe your specific cost serial is mean-reverting, in addition to tell yous accept entered into a long position when the cost is low. Now, however, the cost gets much lower, in addition to yous are suffering a large unrealized loss. Well, based on your mean-reverting belief, yous should purchase to a greater extent than instead of liquidating! Indeed, if yous backtest the number of stop-losses on mean-reverting strategies, yous volition close inevitably discovery that they decrease the overall returns in addition to fifty-fifty Sharpe ratios.

But what this simplistic sentiment ignored is 1) survivorship bias, in addition to 2) dark swan events. (Hat tip: Ben, who prompted me to reckon these ii issues.)

1) We unremarkably would alone merchandise those cost serial alongside a mean-reverting strategy alone if nosotros run into that the prices did eventually revert. No ane would bother to merchandise those cost serial that used to mean-revert, but all of a abrupt stopped doing so. But maxim that stop-losses are harmful to mean-reverting strategies is ignoring the fact that some mean-reverting volition halt working altogether in addition to would non live on our strategies choice process.

2) Let's define dark swan events equally those that did non travel on inward your backtest period. For example, let's tell yous never had a loss of 20% inward a unmarried day. So if yous backtest a stop-loss of 20%, it volition accept no number whatsoever on your backtest performance. However, no ane tin tell for sure that it won't travel on inward the future. So if yous or your investors exactly cannot tolerate a 20% loss, yous should impose this equally a stop-loss. (After all, your brokerage has already imposed a stop-loss of 100% on yous whether yous similar it or not.)

We tin inward fact plow betoken 2) roughly when deciding what stop-loss to use: a stop-loss should live liberate plenty in addition to then that it should accept no number on the backtest performance, in addition to of course of pedagogy tight plenty in addition to then that it volition non resultant inward the demise of your trading career.

There is too the number of whether to purpose stop-loss on the intraday drawdown, or to purpose it on the multiple-day drawdown. I would struggle that alone intraday stop-loss is of import to forestall a black-swan loss. In practice, when a strategy has a string of non-catastrophic losses occurring over multiple days, resulting inward a large, unprecedented, drawdown, the trader volition typically re-examine the strategy, taking into concern human relationship this most recent functioning in addition to tweak the strategy in addition to then that it could theoretically live avoided. This is close similar a multi-day stop-loss strategy, equally nosotros halt an old strategy in addition to showtime a new, modified, one. (Though the modified strategy mightiness soundless recommend that yous conk along asset the electrical flow position!)

Now why am I soundless asset love to the regulation that ane should non impose profit-caps on momentum strategies? Why, the possibility of dark swan events again! But this time, whatever dark swan tin alone resultant in unprecedented one-day gain instead of loss, since nosotros should always have stop-losses on momentum strategies. We for certain don't desire to impose a profit-cap to dominion out this possibility!