Beta-Adjusted Trading Stops

by Thomas Bulkowski

Have you ever wondered how to improve the performance of your favorite indicator or trading system? By using your indicator to signal a buy and a beta-adjusted trailing stop to get you out, you could improve your investing results.

"During my quest for the perfect trading system, I noticed that the use of a trailing stop significantly improved performance of the system. The improvement did not apply to just one trading system; it applied across numerous indicators and strategies that I tested. In my testing, it became clear that the buy and sell signals should be treated independently. This is why you may want to have two indicators in your system: one to get you in and one to get you out. Here's a technique I developed called BATS, a beta-adjusted trailing stop, that uses the stock's beta to adjust the setting of a trailing stop-loss."

Stop-loss points can be determined in numerous ways: support and resistance levels, dollar loss, percentage loss and so forth. There are also different types of protective stop-loss orders -- breakeven, trailing or progressive, profit objective, time and so forth. In doing research, I came across a method in Dun & Bradstreet's Guide to $Your Investments$ that sets a stop-loss price according to a stock's beta and further adjusts the stop to account for a stock price, the idea being that a stop set according to a stock's volatility allows daily price fluctuations to be ignored. You get stopped out when the trend changes against you and not because the stock had a large daily trading range.

To create a table of stop-loss percentages, first I did a frequency distribution on my database of stocks according to beta. This is shown in Figure 1. Frequency distribution is a fancy name for simply counting the number of stocks within a given beta range. Beta is a measure of the volatility of a stock compared with an index or average. The Value Line Investment Survey, for example, compares a stock with the New York Stock Exchange Composite Index. A beta of 1.50 means that a stock tends to rise or fall 50% more than the NYSE Composite Index.

Figure 1: Only a few entries of the 224-stock table are shown. Note the preponderance of high-beta stocks (155 over 1.0 compared with 69 below). Higher-beta stocks have larger price declines compared with lower-beta stocks and require a larger stop-loss percentage to compensate for the increased volatility. The last row shows performance-adjusted stop-loss values of the prior row and is called the major table.

If you use your favorite indicator to time the purchase, then use the beta-adjusted trailing stop to tell you when to sell; your trades may be more profitable.

Thomas Bulkowski has a bachelor's degree in computer engineering and uses his software engineering skills to further his full-time investment activities.
He can be reached at 210 Stallion Drive, Keller, TX 76248.
Excerpted from an article originally published in the January 1997 issue of Technical Analysis of STOCKS & COMMODITIES magazine. All rights reserved.
© Copyright 1996, Technical Analysis, Inc.

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