The science of the stop loss
"Profits look big only to the extent losses are kept small."
– Michael Martin
Most market participants have some vague idea that losses hurt the bottom line. They have just never really visualized the damage. Losses work geometrically against you. A 50% drawdown means you will have to make 100% profit just to get back to break even. As an example: someone buys a stock at 100. You take the other side of the trade and escort it down to 50. The tourist holds on all this time because the long-term story is still intact. That obstinate amateur will have to clock 100% to make it back to break-even.
The innocuous graph below shows something powerful enough to convince any rational market participant that keeping losses small is the only way to go. The lower line represents drawdowns from peak to -90%. The upper line represents the percentage growth needed to recoup those drawdowns. At -10% drawdown, the account must...
