01 Jul Learning From Kaminski & Lo's "When Do Stop-Loss Rules Stop Losses"
If markets follow the Random Walk Hypothesis, stop loss rules has no value. If markets exhibit momentum effects, research shows that stop loss rules can improve returns and reduce risk.
In this article, Absolute Momentum will be used interchangeably with trend following or time series momentum. Relative Momentum will be used interchangeably with cross-sectional momentum or relative strength.
The authors showed that stop loss rules does not add value to mean reversion strategies. Mean reversion strategies, as its name suggest, profit from reversal in price. Stop loss rules might cause the strategy to miss reversals and lower the expected return of the strategy.
For momentum strategies, stop loss rules generally improve returns and reduce risks of the strategies. When losses tend to persist, stop loss rules allow the strategies to switch out after certain cumulative losses.
If markets follow the Random Walk Hypothesis, there are no conditions under which the stop loss rules can add value.
Research Paper: When Do Stop-Loss Rules Stop Losses
Authors: Kathryn M. Kaminski, Andrew W. Lo