Thursday , 23 May 2024

How to Design An Objective ‘Stop Loss’ Method (2K Views)

No one ever likes to lose money and one of the best ways to do so is to set, in advance, at what point you are going to sell your security. You can either do it by simply setting a $ price point or a % decline point at which to sell. Such an approach, however, is fraught with emotion and procrastination. There is a more objective way to accomplish the same objective. Words: 636

In edited excerpts from his original article* on the matter Richard Shaw ( goes about telling us how:

This discussion is not relevant or useful to:
a) those involved in short-term trading;
b) those who do not believe in exiting positions (who are strict “buy and hold” adherents);
c) those with very long-term horizons AND iron stomachs capable of withstanding large fluctuations in portfolio value;
d) those who would have the opposite reaction of a stop and instead wish to buy more when their positions tank.

For everyone else these three important concepts must be recognized:

1. You want your stops to be outside of the “noise” level of seemingly random price fluctuation. If you place stops outside of “reaction” levels, you will automatically be outside of the “noise” level.

2. You want your stops to be outside of the “reaction” range that is likely to occur. If the “reaction” level is outside of your personal emotional or financial limits, then you probably should not own the security.

3. You want your stops to be within your personal emotional or financial limits. Your personal limits are something only you can know.

“Reaction” levels may be reasonably estimated by examining three quantitative parameters that are easily accessible, and then setting your stops outside of the greater of the three. We think these three parameters each divided by the price are informative and useful in selecting a stop loss percentage for trailing percentage stops:

1. The width of the 3-month price channel

2. The width of the 3-month 2 standard deviation Bollinger Bands

3. The spread between the price and the 200-day simple moving average

4. It may also be good to consider the 3-month average of the 3-month Bollinger Band width as an additional parameter.

As an example, if you were to do that today to see where percentage trailing stops might be set for six ETFs representing key asset categories, we come up with these values:

1. US stocks (VTI) 13.6%
2. EAFE stocks (VEA) 14.2%
3. Emerging market stocks (VWO) 17.4%
4. Aggregate US bonds (BND) 2.0%
5. Developed non-US sovereign local currency bonds (BWX) 7.0%
6. Emerging market sovereign Dollar bonds (EMB) 7.2%

We must admit that the 2% on aggregate US bonds seems thin, but that’s what the current numbers say. If you feel the same way, you might chose a longer term factor, maybe as far as the current yield level of 3.9% (so you would do no more than give up the equivalent of one year of income, but not principal).

Note also that for BWX, the price is below the 200-day simple moving average so there is no way to use that parameter in the stop calculation — except to say that we think you should not own it while the price is below the 200-day average, unless you have some special knowledge or beliefs about the Euro/Dollar and the Dollar/Yen, and the European sovereign credit crisis.


Editor’s Note:
– The above article consists of reformatted edited excerpts from the original for the sake of brevity, clarity and to ensure a fast and easy read. The author’s views and conclusions are unaltered.
Permission to reprint in whole or in part is gladly granted, provided full credit is given.
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