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Taming Momentum Crashes: Implementing a Simple Stop-Loss Strategy

Last Updated on 10 February, 2024 by Rejaul Karim

In the paper “Taming Momentum Crashes: A Simple Stop-Loss Strategy,” authors Yufeng Han, Guofu Zhou, and Yingzi Zhu delve into the potential advantages of utilizing a stop-loss strategy to curb the downside risk often associated with momentum strategies.

Analyzing data from January 1926 to December 2013, the authors propose a 10% stop-level and note significant reductions in maximum monthly losses for both equal- and value-weighted momentum strategies. Furthermore, the study reveals that implementing a stop-loss strategy can lead to considerable improvements in Sharpe ratios.

A general equilibrium model consisting of stop-loss traders and non-stop traders is also presented, showing how the market price deviates due to the existence of stop-loss traders in comparison to their absence.

This research provides essential insights for investors looking to minimize the downside risk associated with their momentum portfolios while still maintaining favorable returns.

Abstract Of Paper

In this paper, we propose a stop-loss strategy to limit the downside risk of the well-known momentum strategy. At a stop-level of 10%, we find, with data from January 1926 to December 2013, that the maximum monthly losses of the equal- and value-weighted momentum strategies go down from -49.79% to -11.36% and from -64.97% to -23.28%, while the Sharpe ratios are more than doubled at the same time. We also provide a general equilibrium model of stop-loss traders and non-stop traders and show that the market price differs from the price in the case of no stop-loss traders by a barrier option.

Original paper – Download PDF

Here you can download the PDF and original paper of Taming Momentum Crashes: A Simple Stop-Loss Strategy.

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Author

Yufeng Han
University of North Carolina (UNC) at Charlotte – Finance

Guofu Zhou
Washington University in St. Louis – John M. Olin Business School

Yingzi Zhu
Tsinghua University – School of Economics & Management

Conclusion

In conclusion, the research paper demonstrates the effectiveness of a stop-loss strategy in mitigating the downside risk inherent in momentum strategies. With a 10% stop-level, the study reveals significant reductions in maximum monthly losses and considerable improvements in Sharpe ratios for equal- and value-weighted momentum strategies based on data from January 1926 to December 2013.

Furthermore, the researchers introduce a general equilibrium model comprising stop-loss traders and non-stop traders, illustrating the impact of stop-loss traders on market price deviation.

This paper offers valuable insights for investors seeking to minimize the downside risk of their momentum portfolios while maintaining optimal returns, showing the potential benefits of incorporating a stop-loss strategy into their investment approach.

Related Reading:

Time-Varying Sharpe Ratios and Market Timing

Short-Term Momentum and Reversals in Large Stocks

FAQ

Q1: What are the key findings regarding the effectiveness of the stop-loss strategy, and how does it impact the performance of equal- and value-weighted momentum portfolios?

Analyzing data from January 1926 to December 2013, the study finds that implementing a 10% stop-loss strategy significantly reduces maximum monthly losses for both equal- and value-weighted momentum portfolios. The maximum monthly losses go down, and Sharpe ratios more than double, indicating considerable improvements in risk-adjusted performance.

Q2: What additional contribution does the paper make by introducing a general equilibrium model, and how does it illustrate the impact of stop-loss traders on market prices?

The paper introduces a general equilibrium model that includes both stop-loss traders and non-stop traders. This model illustrates how the presence of stop-loss traders influences market prices compared to a scenario without stop-loss traders, akin to the impact of a barrier option. This adds a theoretical dimension to the understanding of the market dynamics influenced by stop-loss strategies.

Q3: How can investors benefit from the insights provided in this research paper, and what considerations should they take into account when incorporating a stop-loss strategy into their investment approach?

Investors can benefit by gaining insights into how a stop-loss strategy can effectively manage the downside risk associated with momentum portfolios. Considering a 10% stop-level, investors may achieve significant reductions in maximum monthly losses and improved Sharpe ratios. However, it’s essential for investors to carefully evaluate their risk tolerance, investment goals, and market conditions when incorporating a stop-loss strategy into their investment approach.

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