Some traders believe that good risk management means imposing stop loss on every trade; that is, if a position incurs a certain percent loss, the trader will exit the position. It is a common fallacy to believe that imposing stop loss will prevent the portfolio from suffering catastrophic losses. When a catastrophic event occurs, securities prices will drop discontinuously, so the stop loss orders to exit the positions will only be filled at prices much worse than those before the event. So, by exiting the positions, we are actually realizing the catastrophic loss and not avoiding it. For stop loss to be beneficial, we must believe that we are in a momentum, or trending, regime. In other words, we must believe that the prices will get worse within the expected lifetime of our trade. Otherwise, if the market is mean reverting within that lifetime, we will eventually recoup our losses if we didn’t exit the position too quickly.

Of course, it is not easy to tell whether one is in a momentum regime (when stop loss is beneficial) or in a mean-reverting regime (when stop loss is harmful). My own observation is that when the movement of prices is due to news or other fundamental reasons (such as a company’s deteriorating revenue), one is likely to be in a momentum regime, and one should not “stand in front of a freight train,” in traders’ vernacular. For example, if a fundamental analysis of a company reveals that it is currently overvalued, its stock price will likely gradually decrease (at least in relation to the market index) in order to reach a new, lower equilibrium price. This movement to the lower equilibrium price is irreversible as long as the fundamental economics of the company does not change. However, when securities prices move drastically without any apparent news or reasons, it is likely that the move is the result of a liquidity event—for example, major holders of the securities suddenly need to liquidate large positions for their own idiosyncratic reasons, or major speculators suddenly decide to cover their short positions. These liquidity events are of relatively short durations and mean reversion to the previous price levels is likely.

Quantitative Trading – Ernest P. Chan
ISBN 978-0-470-28488-9