Trend-following with stops reduces drawdowns

 

A core question with any trading strategy is whether or not to use stops. The answer is not always clear. It is clear that having stops too close will reduce return because  many good positions are lost to reduce risk, it is often an empirical question of the value of this risk management tool. A recent paper set-up a simple model across all major assets classes to determine the value of stops. This work is not definitive and is just an example, but it does add to the discussion.  See "Cross-asset trend following algorithm".

I will not go through all of the assumptions to get these results, but the base model represents a long-term trend model based on a moving crossover model using 50 and 100 days with stops based on a multiplier using the average true range. The data includes 39 assets over a 32-year period.

For the long/short portfolio there is a slightly lower Sharpe ratio when stops are used, but there is a significant decline in the maximum drawdown. A stop-loss will not support higher returns. A review of the cumulative returns chart shows a marked difference in the return pattern.