How we set Stop Losses

A critically important component of the TurnerTrends investment strategy is the use of Stop Losses to protect our downside risk and to get us out of a stock at the right time. Just about everyone understands the concept of a Stop Loss setting. This is where you set the price you are willing to sell (in the case of long positions) or where you are willing to cover (in the case of short positions).

But, the real key to using this strategy is knowing what makes the best Stop Loss? Set the Stop Loss too close to the current stock price and you run the risk of getting out of the stock too soon. Set the Stop Loss too far away from the current price and you run the risk of a significant loss if the stock’s price moves strongly against you.

We set our Stop Losses for one week at a time. TurnerTrends has developed a formula of the maximum amount a stock should move before the close of the next Friday. This formula uses historical pricing volatility, time, and the Friday closing price of the stock.

This formula tells us that 68% of the time, a stock’s price should not move more than a specific amount either up or down from the Friday close. The result of this calculation is called the stock’s Expected Move (EM).

So, if we want to buy a stock and are willing to suffer a maximum loss of its EM, then we would set its Stop Loss at the Friday closing price less the Expected Move, less one cent. This tells us that 68% of the time this stock’s price will not go below our Stop Loss for the upcoming week.

Let’s say that IBM just gave us a BUY signal and closed on this past Friday at $89.75. Using our formulas, we calculate that IBM’s historical volatility is 20% and its Expected Move is $2.68.

This means that, statistically speaking, 68% of the time we can expect that the price of IBM stock in the upcoming week will trade between a high of $92.43 and a low of $87.07.

So, if we decide to take a position in IBM, we would set our Stop Loss at $87.06; just one cent below its EM.

As we move forward in time, we adjust the Stop Loss each week after we have re-calculated its EM. However, we do not lower a Stop Loss (for long positions), but only* raise it. At some point in the future, IBM’s share price will begin to trend downward. When this trend begins, we will want our Stop Loss to trigger a sale of the stock so we can get out.

The goal of this process is to hold stocks long enough for them to achieve a Stop Loss setting that is higher (again for long positions) than our basis in those stocks. Then, when our Stop Loss is triggered, the transaction generates a profit for the portfolio.

*Note: Each week, we perform a complete re-calculation of the past three years of each stock’s pricing history to determine the current HV (Historical Volatility) and EM (Expected Move). Occasionally, this re-calculation will result in a lowering of a Stop Loss, relative to the previous week’s Stop Loss. But, this new Stop Loss is NOT lowered from the re-calculation of last week’s Stop Loss.