From subscriber on email: "I would like to put a trailing stop on the backtest and/or investigate what would happen if I stopped and moved to cash."
This is one of the more common questions we get on email from members.
First off, built into the ETFreplay architecture IS a natural form of stop. A stop is of course a point at which you exit -- either by moving to cash or moving to another security. A good relative strength backtest will naturally move towards the performing ETF(s) and away from the non-performers. We have different trade interval choices on ETFreplay and if you choose say monthly, then you have a stop built-in -- it is just a 'time-interval (monthly) stop.'
Yes you are essentially locking in a full months performance and not exiting immediately and people often view this as risky -- but that is NOT what the evidence shows. Having the perception of being 'less risky' instead just means you 'feel emotionally better because you are out of the market.' Holding on until month-end and accepting that extra time-risk is often dramatically better than locking in a loss at a percentage.
Why? Because first, stops usually get hit as market gets oversold and then it bounces back and you end up rotating at a dis-advantageous on the stop-price.
But importantly there is a second reason, the market often not only bounces -- it recovers back strongly and sometimes back to a new swing high and you end up NOT rotating and are sitting on a paper non-taxable gain rather than having taking a real loss and now in cash and out of the market potentially missing more upside.
This second case has happened many times during the bull market that began a few years ago. If you stopped out, did you get back in higher?? Many times that might be emotionally tough to do. If you accept the calendar month return, you might occassionally be worse off -- but this is usually offset by the 'death by a thousand cuts' underperformance risk so many twitchy traders suffer from....
But what about stops as many people read about in all those trading books?
Trading books are almost always based on things that have no ETF research or backtest support, many no backtest support at all. Some recommend a 'percentage based stop' (ie, stop if XYZ drops by -8% from your purchase price). Those that say they have research behind their method don't present the actual results and instead have done limited testing and made conclusions based on one set of detailed assumptions. These are also almost always done on individual stocks -- not ETFs. We are experts in ETF backtests and people should be aware that backtesting an ETF is NOT the same thing as backtesting an individual stock. We have done a fair bit of work on individual stocks too -- but find that individual stocks are extremely noisy and it takes a tremendous amount of trading activity (many small positions to offset the added noise) to actually implement anything where the statistics can back it up. Many invstment advisors simply can't do such things as trade hundreds and thousands of individual stocks every month or quarter. (And as you can see in hedge fund results, neither can hedge funds that try to do it).
Also with individual stocks, you are always worried about a total cratering -- your stock potentially becoming a penny stock or bankrupt. But even if you forget that ultimate risk, many stocks can lose tremendously more than a typical index ETF and simply not recover wheras an index of many stocks will recover. Many past stocks that had large weightings in an index collapsed and the index not that soon after went back to new highs -- think Bank of America or Cisco Systems or worse Worldcom and countless others that were at one point considered core holdings. With individual stocks, you cannot take hits like that that and never rotate away. The losses can be huge and importantly, the opportunity cost of sitting in a dead stock long past its prime can cause you to dramatically underperform.
Some of the hidden beauty of an index is that they by rules-based methodology let winning stocks and groups of winning stocks grow in weighting while broken stocks of past cycles lose their significance (weighting).
While time-interval stops can work for individual stocks too, we are more concerned with how this all applies to ETFs since ETFs work much better for trading practicality reasons (after all, trading an ETF is exactly the same thing as trading a large basket of stocks all at once). You get hundreds or even thousands of trades (and the associated altered exposure) for the cost of zero (assuming you are in a free trading program like Schwab, Ameritrade or others have).