Ask Mike:
Please explain how you arrive at the stop loss settings.

Question:

Mike,

Could you address your theory in setting and using stop losses?

Craig R from Plymouth, MN

Mike's Response:

Hi Craig,

I devote an entire section of my upcoming book (due out in October) to your question. I will summarize parts of that section here...

My theory for stop loss setting relies on the following assumptions:

1. It is important to get out of a position as near the top of its current upward trend.
2. The key to timing this exit is to differentiate between normal stock pricing fluctuations and a new downward trend. In fact, this is the goal of every technical analysis system... how to know the difference between volatility and trend.
3. Ideally, one should try to stay just below normal volatility ranges, but high enough to keep from losing a lot of paper profits when the trend in a stock reverses. And... of course, a stock always starts its reversal with a downward move that looks identical to normal volatility movement. Staying just below normal volatility should, in theory, keep you from getting whip-sawed (i.e., getting out/in/out/in of the market where the only person making money is the broker).
4. If a stock's Expected Move (see below) becomes greater than one standard deviation of the norm, there is a significantly greater likelihood that the stock has moved into a new trend. So, if the stock's price moves lower than the Expected Move, the risk becomes too high to continue to hold the stock as it is now exhibiting more likelihood that it has begun a downward trend.
5. If a stock's Industry is in Bear Mode (average price of all the stocks in the Industry are below the 50 day moving average, time-shifted forward by 3 weeks), then there is a significant amount of downward pressure on the stock's price.
6. Peer leading stocks tend to be some of the last to move lower when the stock's Industry begins to move from Bull mode to Bear mode.

Here are the steps I use to calculate a stop loss setting for stocks (I have a slightly different variation of this process that I use for ETFs...):

Step 1:
Determine the normal weekly volatility of a stock. Weekly volatility is determined by taking comparing the week's highest high and the week's lowest low for each of the previous 52 weeks. I use the average of that weekly delta.

Step 2:
Use the Back-Shoals formula for calculating the Expected Move (EM) of a stock for upcoming trading week. The EM for a stock is the theoretical amount the stock's price will move and stay within one standard deviation of the norm.

Step 3:
Then, I subtract the Expected Move from the previous week's lowest low. I set the stop loss one penny below that price.

Step 4:
If I have more than 15% in unrealized gain and the stock's Industry is in Bear mode, I reduce the EM by 75%. This, in effect, moves the stop loss up much closer to the stock's current price.

Thanks for the question.

Regards,

Mike