Stop-Loss Rules and Drawdown Management

Every portfolio manager has a stop-loss policy — either an explicit one she designed, or an implicit one she will discover at the worst possible moment. The difference is not whether one exists but whether its parameters are calibrated rationally to her Sharpe ratio, investment horizon, and the fund's loss tolerance. An explicit stop-loss is also a partial hedge for the PM's own incentive problem: because the PM is paid a percentage of profits, she holds a call option on portfolio returns — an option whose value increases with volatility, giving her an incentive to run excessive risk at the fund's expense. Stop-loss rules constrain this option. Understanding the cost-benefit trade-off of stop-loss thresholds is a prerequisite for setting them correctly.