As I prepared to write this article, my stated intent was to review available research on breakeven stops, mix this with my own experience as a trader and trading coach, and come to a somewhat definitive philosophical, experiential, and research-based conclusion on their use.
I have succeeded. Emphasis, however on the phrase “somewhat definitive.”
And a couple of funny things happened on my way to find certainty in the land of breakeven stops. The first: I was reminded that when we dig into the nuts and bolts of the financial markets, it’s almost impossible to uncover very much certainty. Can you find high probability? Occasionally. A nice trading edge? Sure. Certainty? Not so much.
The second: I found myself losing sight of why I was doing this. My intent was to help fellow traders and investors understand some of the best practices for intra-trade risk management. What really happened was that the engineering part of my brain kicked in. I found myself digging deep into the data of the few research pieces that I found, and then generating my own data. Then, I realized that I was like a pig wallowing in the mud. It’s really fun and it feels good on a hot day, but it really doesn’t get you anywhere!
Which is why I added the second quote for today. I really couldn’t see the forest for the trees. (I had lost sight of the big picture by being absorbed in the minutiae). Interestingly, that phrase has been around for centuries—dating back at least to 1546 when it was included in John Heywood’s collections of English language proverbs. Yet I digress (again!).
Back to Seeing the Forest—It’s All About the Patience
To get to the big picture, it actually is useful to take a look at some of the individual trees to know what type of forest we’re looking at. Are they coniferous? Deciduous? Our trees are the research studies.
I pulled 11 books on trading systems off of my shelves and found only two that addressed breakeven stops in more than a cursory way. Both are oldies but goodies: Chuck LeBeau’s and David Lucas’ excellent book Computer Analysis of the Futures Market and Bruce Babcock’s Guide to Trading Systems.
Both of these studies dealt with using breakeven stops in trend following systems. Babcock is very negative philosophically on the use of breakeven stops, and his limited analysis using two different levels of profit to trigger a tightening to a breakeven stop showed that breakeven stops hurt profitability but reduced drawdowns—a minor negative for the breakeven stop camp.
Chuck’s study used a reversal/always in the market moving average crossover system. He found that breakeven stops helped the results. However, my bias here is that always-in-the-market systems are weak to begin with, so the addition of any exit that keeps you out of the market when it’s acting badly relative to your system is a good thing. Nonetheless, this has to be considered a positive for the breakeven stop.
The last study was published by Bandy in Active Trader magazine and was much broader than the first two. It covered 4000+ Exchange Traded Fund trades over almost 5 years. His conclusion was that moving a stop loss to breakeven dramatically reduces profitability. He applied his exit testing to a system that entered on the last day of the month and exited at the end of the next month. So it was basically testing exit strategies with a timed random entry (meaning no other entry or set-up signals were used to filter entry).
In my early studies for counter trend strategies, I have not been able to find a breakeven stop method that improves performance by a statistically significant amount. When my studies are concluded (or at least further along), I’ll pass the conclusions on.
The bottom line is that breakeven stops are psychologically comforting. Moving to breakeven allows us to mentally “play with the market’s money.” However, under most scenarios, it seems that breakeven stops are not helpful in making trading profitable. (Chuck’s upgrade to a moving average reversal system was the only one that I could find that favored breakeven stops).
And for the day traders that I work with regularly, I think the allure of the free trade or playing with market’s money leads to moving stops up far too quickly. I’ll reiterate that for traders newer to the game, leaving stops in their original protective position and having the patience to wait for the trade to develop will serve you best to learn the craft and to get the occasional bigger winner that really drives longer term equity increases.
Thanks to everyone who commented on last week’s article. If you have comments on this series or have references to other breakeven stop studies that might be useful.