It is repeated over and over again that stop loss is necessary. And those who trade without one are doomed. But is it really essential?
The Conventional Wisdom
"Always use a stop loss" is perhaps the most repeated advice in trading. The logic seems unassailable:
- Limits your losses
- Prevents emotional decisions
- Protects your capital
But like many things in trading, the truth is more nuanced.
Maximum Adverse Excursion (MAE) Analysis
To understand how stop losses affect strategy performance, we use Maximum Adverse Excursion (MAE) – the largest loss suffered by a trade while it is open.
The Surprising Finding
Looking at our momentum breakout strategy, we found something counterintuitive: trades experiencing severe temporary losses (exceeding -20%) frequently recovered and ended profitably or with minimal losses.
This demonstrates that markets tend to revert during extreme moves, making premature exit strategies counterproductive.
Performance Comparison
We tested the same strategy with and without stops:
The results were striking:
- 20% Stop Loss: Would have resulted in 46% more losses than no stop loss
- 10% Stop Loss: Would have resulted in 27% more losses than no stop loss
Even stopping out on trades that eventually declined to -20%, -30%, or lower, the stop loss strategy underperformed.
Why Stops Hurt Mean Reversion
Mean reversion works by buying "oversold" assets. But how do you know when oversold becomes "more oversold"? You don't.
A mean reversion trade that goes against you may simply be offering a better entry. A stop loss forces you to exit when you should be holding (or adding).
When Stop Losses Help
Trend Following
Trend following REQUIRES stops. The strategy is based on cutting losers quickly.
With stops: Many small losses, occasional big wins = Profitable Without stops: Few big losses wipe out all gains = Disaster
Breakout Trading
Similar to trend following – you need to exit failed breakouts quickly.
High Leverage
If you're using significant leverage, stops prevent catastrophic losses.
Shorting
When shorting, using stop losses as protective measures against "black swans" makes sense.
Better Risk Management Approaches
If not stop losses, then what?
1. Portfolio-Level Risk Management
Instead of individual trade stops, manage risk at the portfolio level. Diversify across uncorrelated strategies.
2. Position Sizing
Risk less per trade. If a 20% adverse move is acceptable, size your position so that 20% move = 1-2% of account.
3. Proper Exit Strategies
Develop exit strategies based on research, not arbitrary price levels. Time stops, trailing stops, or indicator-based exits.
4. Reconsider Leverage
If you need tight stops to manage risk, you may be using too much leverage.
The Middle Ground
Some traders use a "catastrophe stop" – a very wide stop that only triggers if something is fundamentally wrong:
- Normal trade: No stop
- Catastrophe stop: 25-30% below entry
This protects against true disasters while avoiding whipsaws.
Conclusion
"Always use a stop loss" is not universal truth. Stop loss functions as risk management rather than exit strategy.
The right approach depends on:
- Your strategy – Trend following needs stops; mean reversion may not
- Your timeframe – Shorter timeframes = tighter stops make sense
- Your position sizing – Smaller positions can survive without stops
- Your leverage – Higher leverage requires tighter risk controls
Proper research and risk management are essential for sustainable trading success. Question everything – including the most repeated advice.
Pavel – Robuxio