A Statistical Method for Setting Stops in Stock Trading

This paper applies the exponential distribution to stock price reactions to determine, at three confidence levels, the critical percentage price reaction beyond which a reaction constitutes a strong likelihood of a major reversal or halt in the stock's present general price trend. We show that these critical values can be used to determine stop losses, so that a trader's position is closed when the probability of a major reversal or halt against his position is large, and an open position is kept open when the probability that the reaction is a major one is small or moderate. The distribution fit on ten stocks on daily and weekly bases for over a year's duration each, tested using the chi-squared statistic, was found to be good. Further, three stops, corresponding to three confidence levels of the distribution were tested for each stock against a subsequent six-month period of price action. The percentage of successful tests of these stops for each of the stocks corresponded very closely to expected results ascertained by using data from the previous period.