Using Trailing Stop-Loss Rules to Reduce Risk

Stop-loss rules are widely used in financial markets. The rules involve selling a security when its price drops below a pre-determined threshold and repurchasing the security when its price rises above a pre-specified level. While there are different types of stop-loss rules, our research focuses on the popular trailing stop-loss rules.

Our trailing stop-loss approach involves selling the stock when the values decline and repurchasing it when the value increases. The initial sell trigger price is set at X% below the original purchase price. If the stock value does not increase, the sell trigger price remains at the original level. However, if the stock price increases beyond the initial purchase price, the sell trigger price is increased so that it is below each new high price. When the price falls, a sell signal is generated. We sell the stock and purchase T-bills (Treasury Bills are government-guaranteed debt instruments) the day after the sell signal. As with the sell trigger price, the buy trigger price decreases if the stock price decreases below the initial purchase price so that it is X% above each new low price.

We investigated the performance of trailing stop-loss rules compared to a benchmark for U.S. stocks over the 1926–2016 period. We considered several trailing stop-loss thresholds, which varied from 1% to 20%. Our results show that while trailing stop-loss portfolios exhibit lower total risk than their benchmark, the trailing stop-loss strategy experiences lower returns. The trailing stop-loss Sharpe ratios are also lower than their benchmark (a Sharpe ratio is the measure of risk-adjusted return of a financial portfolio. A higher ratio is considered better). However, our findings highlight the benefits of trailing stop-loss rules in reducing downside risk relative to their benchmark. Further analyses show that trailing stop-loss rules have become more effective at reducing downside risk over time.  Adding value to control downside risk in declining markets and performing better in terms of downside risk reduction on stocks that are more volatile, more liquid, and with a lower book-to-market ratio.

When we account for the impact of transaction costs on the performance of the trailing stop-loss rules, we find that the outperformance of trailing stop-loss portfolios in downside risk reduction disappears for stop-loss rules tighter than 10%. Three factors drive such results. First, there is a higher portfolio turnover among the trailing stop-loss rules with tight thresholds. Second, transaction costs are generally higher during the market declines, which coincide with the period in which the trailing stop-loss rules trade. Third, in an extreme event like a market crash, transaction costs will also jump substantially, which increases the magnitude of downside risk after transaction costs. Nevertheless, the trailing stop-loss rules with high thresholds (from 10% to 20%) still have significantly lower downside risk after transaction costs compared to their benchmark.

Our research highlights the importance and implications of the path of returns in addition to the average return. It shows that trailing stop-losses are specifically designed to limit downside risk and prevent periods of large losses.

This overview is based on the paper entitled “Risk Reduction Using Trailing Stop-Loss Rules”, authored by Bochuan Dai, Ben R. Marshall, Nhut H. Nguyen, and Nuttawat Visaltanachoti, and published in International Review of Finance

Alternative link: https://doi.org/10.1111/irfi.12328