The Investment U E-Letter: Issue # 426
Thursday, April 7, 2005
Trailing Stops Tested: Do Trailing Stops Really Work?
By Dr. Steve Sjuggerud, Advisory Panelist, Investment U
Does the use of trailing stops really work? Emotionally, yes… By having a system that forces us to cut our losers and let our winners ride, we stay in the position of always being a winner. But what about statistically? Does the math really work? Investment U reader Richard Smith set out to answer this question. And Richard is one gentleman who has the capability to get to the bottom of things… He has a PhD. in math and a degree from Cal Berkeley. He also is a knowledgeable trader and computer programmer. It turns out trailing stops do provide a benefit, based on our (very preliminary) evidence. Our goal was to see if a simple trailing stop could improve a system. In our test case, it did. It brought home a higher total return than the system tested, with less risk - less time in the market. If you'd like to know the math of what we did, you can read on. But you don't need to… this is all you need to know: Based on our first test, trailing stops appear to have the ability to improve a trading system, where you can achieve the same overall return, with less risk - less time in the market. The Simple Trailing Stops Test Here's what we did: We took a simple trading system. And then we added a trailing stop to that trading system. Next, we compared the results of the basic system (without trailing stops) to the system with the stops added. Here's what we found… We tested the S&P 500 from 1927 through the end of 2004, using weekly data. Our simple system was a 45-week moving average system… The simple system goes like this: - Buy when S&P 500 closes a week above its 45-week moving average.
- Sell when the market closes a week below its 45-week moving average.
Simple enough. Most academics don't want to acknowledge that a moving-average strategy could be effective at reducing risk and increasing returns (because it would blow all their existing theories about "market efficiency" and "fundamentals" out of the water). Yale's Jeremy Siegel did test it in the book Stocks for the Long Run, and concluded: "The major gain from the strategy is a reduction in risk. Since you are in the market less than two-thirds of the time [the way he tested it], the standard deviation of returns is reduced by about one-quarter. This means that on a risk-adjusted basis, the return on the 200-day moving average strategy is quite impressive." Even with the worst of assumptions, Siegel said, "there is no question that the 200-day moving average strategy, even with transactions costs, avoids large losses while reducing overall gains only slightly." (The strategy Siegel tested in the book also included 1% "bands" to eliminate "whipsaws," where the index bounces above its moving average one day, and then below it the next. To stick close to what he did, we added 1% bands for our test, too. What that means is that a "buy" signal isn't generated until the market closes the week 1% above its moving average, and you don't exit until the market closes 1% below its moving average). Here's What Happens When You Add Trailing Stops to a System Under "BUY AND HOLD" (no trading strategy), the S&P 500 Index was up 5.94% per year since 1927. (Can you believe the number is that low? The S&P 500 Index doesn't include dividends, and the time period studied includes both the Crash of 1929 at the beginning and the Internet bubble at the end, so it's real. But so low!). Using Siegel's strategy (of bands), with our 45-week moving average sample system, stocks returned 8.38% annualized in "buy" mode, which occurred only 32.2% of the time. By adding a 10% trailing stop, the annualized return on stocks improved to 8.94% annualized in "buy" mode. And you were in the market even less… only 30.2% of the time. In both cases (in Siegel's system, and Siegel's system with trailing stops), you were out of the market more than two-thirds of the time. So you had NO RISK for that two-thirds of the time. Because of this, it is true that BUY AND HOLD was the overall TOTAL RETURN winner. However, if you stuck with buy and hold, you had an extraordinary amount of added risk, for not much added benefit. More specifically, if you assume that you went to cash when not in "buy" mode, and that cash earned you 3%, then you'd have STILL made more money overall in buy and hold, but with much more risk. The trading system with the trailing stop came in second in total return. And the trading system with NO trailing stop came in last. These two trailed buy and hold by a little more than 1% annualized a year. But again, you were "invested" less than one third of the time. Conclusions on the Trailing Stops Test Siegel's conclusions about the moving average system are exactly right. And when you apply trailing stops to the moving average system, the results do improve-you're in the market even less, with a higher return. I couldn't have said it better than Siegel: "The major gain from the strategy is a reduction in risk. Since you are in the market less than two-thirds of the time, the standard deviation of returns is reduced by about one-quarter. This means that on a risk-adjusted basis, the return on the… moving average strategy is quite impressive." Again, the 10% trailing stop (see P.S. below) improves on this further. Even with the worst of assumptions, "there is no question that the… moving average strategy, even with transactions costs, avoids large losses while reducing overall gains only slightly." Once again, the use of 10% trailing stops improves this result, too. The goal, of course, wasn't to test Siegel's system. The goal was to see if simple trailing stops could improve a system. We used Siegel's system as a test case. In this first test case, using a 10% trailing stop brought home a higher total return than the system we tested, with less risk - less time in the market. Great! Richard and I are going to keep testing and learning. But this first result is encouraging. Today's IU Cribsheet - For more on Richard Smith and his work on investing, visit http://www.StrataDat.com.
- Today we talk a lot about trading systems. To learn more about them, I strongly urge you to check out the newest Trader's U E-Letter… My good friend and colleague D.R. Barton writes the Trader's U E-Letter. In it, Investment U's vice president teaches you how to trade your way to financial freedom - and quickly, too - by reducing risk while still hunting down massive, triple-digit gains. To get D.R.'s latest tips and recommendations free, visit: http://www.investmentu.com/tradersu/register.html
- Finally, I also want to personally invite you to attend one of my favorite annual events: The Agora Wealth Symposium Vancouver. Taking place at the luxurious Fairmont Hotel, it'll feature the world's top investment minds on options, value investing, alternative investments, momentum stocks and real estate… It's your chance to hear all of Agora's world-class experts - including Oxford Club Founder Bill Bonner - beneath one roof, August 10-14, 2005. For more information, contact Barbara at Agora Travel and Conference Services at 800.926.6575 (toll-free) or 561.243.6276. Hope to see you there!
Good investing, Steve P.S. Why 10% on trailing stops, you may ask? Well, since we were testing the overall stock market, and not an individual stock, we needed a tighter number than the 25% trailing stop I usually recommend for individual stocks. And with a moving average strategy, chances are you'll never hit a 25% trailing stop, as you'd cross over the moving average and get out of the trade before a 25% stop was triggered. But still, why 10% versus, say, 11% or 9%? We don't know, actually… We aren't claiming it's an ideal number. It's simply a good starting point. It's wide enough to let the market fluctuate, and tight enough to be triggered every once in a while, even with the moving average strategy. We couldn't find anyone who'd actually tested stops and shared their results. Even in William O'Neil's classic book How to Make Money in Stocks, where he's a strong advocate of cutting your losses at "7% or 8%," he never tells us how he arrived at his number. Related Articles Investment U Archives | 
