Article #543) Here's why I don't use stop-losses for Volatility ETP trading

Updated: Dec 30, 2020

VTS Community,

Now that I have found myself getting back into a few volatility ETP trades, I have noticed the number of questions coming in regarding stop-losses has increased so I thought I would remind everyone of how I personally deal with this issue.

Short answer, I don't use stop-losses for volatility ETP trading

Longer answer, there's a few reasons I'll get into.  But first I will say if anybody feels personally that using a stop-loss would give them more peace of mind then absolutely you should do that.  Feeling safe in ones investments is absolutely vital.  It's impossible to make good decisions consistently if it's coming from a position of worry and fear.  So if stop-losses make positions more emotionally manageable, use them.  But here's why I don't:

1)  I view all my open positions with fresh eyes every single day.  I check my list of volatility metrics every day to determine whether I hold a position or move to cash.  So technically speaking, no position of mine is ever held longer than 1 single day without it still passing all the requirements of being in the trade.  I am the polar opposite of buy and hold.  I'm always tactical, trading on 1 day time frames.

Now that doesn't mean I'm a day trader.  There are times when I maintain the same position for weeks or months at a time without changing position.  And the volatility strategies on average in the long run only change positions about 2-3 times per month.  But I still check the signals every single day, and only hold on if all the levels are still acceptable.

This in itself is a stop-loss, it's just not a price stop-loss.  It's a single day time frame stop-loss which in my opinion is more effective and cuts down on the whipsaw nature of intraday volatility movements.

2)  The data supports not using stop-losses as well.  Now it's only 8 years of data so I wouldn't say it's conclusive, but overall using intraday stop losses is worse than just waiting the 1 single day and potentially changing positions then.

* From the stop-losses video down below:

I discuss this in more detail in the video below, but even including the February 2018 volatility spike, the data still shows a small advantage to not using stop-losses.  The number of days using an intraday stop loss actually hurts the trader is actually more than the stop-losses help.  If you're wondering how that could be, the reason is volatility does have a mean reversion component to it.  Often times when volatility spikes during the day, after a few hours or into market close it settles back down.  Using an intraday stop-loss can lock in the loss by triggering, only to see it recover later on.  That's called whipsaw, and it's not uncommon at all.  

3)  Proper position sizing.  I've talked about this a ton in the past and I will again many times in the future because of how important it is, but yes maintaining a small overall allocation to higher risk strategies is vital.  A good rule of thumb is, if you feel worry over being in a position, you've allocated too much. 

When I allocate to an SVXY, ZIV, VXX position, I'm not on pins and needles hoping and praying it does something.  If my signals say get in a position, I do, and I don't think about much.  I allow the long-term process to play out.  I'm allocated conservatively so I'm not worried in the least about my current SVXY or ZIV positions.  I'll hold them until my daily process of checking signals in the morning says otherwise, and then I'll exit.  If you do feel any worry, you've allocated too much. 

So that's why I personally don't.  I feel like proper position sizing plus trading on 1 single day time frames is the best combination of safety and performance.  Again though, if you would feel more comfortable using stop-losses then you should.

If you're going to, I would suggest a roughly 10 - 13% intraday stop-loss.  Now you'll have to reset this every day at market open so it does require a little more work, but it should be manageable and if it gives you peace of mind then it'll be worth it.  

One thing that is absolutely vital though is being strict and disciplined with the 1 day rule.

There are times when markets make a move down, but people may feel that it's just a single bad day and should recover the next day, so maybe they hang on and give it one more day.  This is where people get into trouble, because volatility ETPs can make substantial 2-3 day moves.

Waiting that one single day too long can actually be quite costly, so you'll notice that I'm as disciplined as a robot when exiting positions.  There were a couple in the last 6 months where I exited a ZIV or SVXY position on a down day and the very next day it recovered.  When that happens, in hindsight you feel like it was a waste.  But, there are those occasions when a down day is followed by an even larger down day, and that's when the benefit of being completely disciplined comes into play. 

I simply don't allow myself to wait that one extra day.  If the daily signals which I check every morning say I'm out, I'm out!  That's the effective stop-loss and it's kept me safe and able to minimize damage over the years.  Any long term follows will know I'm all about risk management, and if you're new you'll learn this about me soon.  Any opportunities to reduce risk, I jump on them.  So while intraday stop-losses sound like a good idea intuitively, in actual fact the 1 day rule is more effective in smoothing performance.

Enjoy the video, and always feel free to ask follow up questions.

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