Year-to-Date Strategy Stats as of today:
+ 35.43% : Turner Quant Advantage (TQA)
+ 11.83% : Tactical Growth (TG)
+ 3.01% : Diversified Income (DIS)
+ 17.92% : Leveraged Index (LI)
+ 10.97% : S&P 500
I get lots of great feedback from my clients. Their questions help me better assess whether or not I am adequately keeping them informed about how we invest and how we know when to sell.
David sent me an email with the following question: "The stops in place most often fall just below the key moving average support lines, do certain levels of support play a role in setting the stops or is it strictly following 25/50/75/100 percentages of EMs based on risk appetite? "
It is obvious that David is an astute technical trader and wants to better understand how we set stops. He can see the results of those stops, but he is wondering how the actual stop loss prices are calculated and applied. This is NOT a simple subject to explain, but it is an important one. Let's dive into it... (btw... David does not think it is magic, either... I just used that in my title of today's blog to get your attention...)
First, let's define a stop loss: A stop loss is the price at which you want to sell a holding if its share-price drops to that level or below. We, typically, use stop loss settings that always get filled even if the price drops below our stop loss price before it trades. This is called a "stop market", as opposed to a "stop limit", which will only execute if the share-price of a holding trades at exactly the stop limit price. Basically, a stop loss is used to stop further downside losses when a holding suddenly trends in the opposite direction than you want.
Now... Let's go over how a stop loss price is determined...
Using a derivation of a Black-Scholes formula, we calculate one standard deviation of normal volatility. The major inputs to the formula are 12 months of historical volatility and future time of one week. The resultant of this equation is different for every index, ETF and stock. It basically tells us the range of expected pricing movement (67% of the time) of a holding in the upcoming week. We call this range, the equity's Expected Move, or EM. All stops are predicated on this 1-EM value for each holding.
If a holding's share-price moves up from the prior Friday closing price, we move the stop loss up, accordingly. If the share-price moves down from the prior Friday, we do not change the stop loss.
In our Tactical Growth model, we (generally... more on this below) set stops at 1EM below the most recent Friday closing price and do not lower stops over time.
In our Diversified Income model, we use a 2EM stop. This means stops are set at 2 times 1EM below the Friday close.
In our Leveraged Index model, we use a 2EM stop.
In our Turner Quant Advantage, we use up to 3EM stops.
When the "Total Market Index" (a composite of the S&P 500, Nasdaq, Russell 2000 and the Dow) moves to more than 3.75EMs above its 200-DMA, the Total Market Index triggers and "Overbought Warning". An "Oversold Warning" is triggered when the Total Market Index moves more than 3.75EMs below the 200-DMA of the Total Market Index.
When the Total Market Index is in an overbought or oversold condition, we begin raising stops to 0.5EMs (remember... we use inverse ETFs in bear markets, so we raise stops on these holdings as well when the Total Market Index falls more than 3.75 EMs below the TMI's 200-DMA) and if the Total Market Index continues well above the 3.75EMs its 200-DMA (or below in the case of a bear market), we have the discretion to move the stops to 0.25EMs below the then current price of each holding. Depending on the rate of growth in the Total Market Index, we have the discretion to update stops multiple times per day.
There is nothing magical about the 3.75EM level of the Total Market Index, other than historical analysis of this level, typically produces a correction of varying degrees shortly after reaching that level. As such, our goal is to capture profits before a significant sell-off.
One of the top priorities that our clients want us to follow is to NOT lose them a lot of money in a suddenly reversing stock market. Using our volatility-based stops and the trend of the Total Market Index, we are better equipped to adhere to that priority.