This arti­cle is a guest con­tri­bu­tion from Richard Shaw, QVM Group LLC.

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We increas­ingly receive ques­tions about how to set stop loss lev­els.  Let’s look at one objec­tive, data dri­ven way to do that.

You may have a bet­ter way, and that’s a good thing, but if you don’t have a way, and you need a way, this dis­cus­sion may be a help­ful start­ing place to design your own stop loss set­ting method.

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

First, rec­og­nize these three impor­tant concepts:

1. you want your stops to be out­side of the “noise” level of seem­ingly ran­dom price fluctuation
2. you want your stops to be out­side of the “reac­tion” range that is likely to occur
3. you want your stops to be within your per­sonal emo­tional or finan­cial limits.

If you place stops out­side of “reac­tion” lev­els, you will auto­mat­i­cally be out­side of the “noise” level.  If the “reac­tion” level is out­side of your per­sonal emo­tional or finan­cial lim­its, then you prob­a­bly should not own the security.

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

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:

• US stocks (VTI) 13.6%
• EAFE stocks (VEA) 14.2%
• Emerg­ing mar­ket stocks (VWO) 17.4%
• Aggre­gate US bonds (BND) 2.0%
• Devel­oped non-US sov­er­eign local cur­rency bonds (BWX) 7.0%
• 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.

Here is the raw data we used to cal­cu­late the stop lev­els above:

Hold­ings Dis­clo­sure:
As of April 9, 2010, we hold BND, EMB, and VWO in some, but not all man­aged accounts, and not nec­es­sar­ily all in any sin­gle account.  We do not have cur­rent posi­tions in any other secu­ri­ties dis­cussed in this doc­u­ment in any man­aged account.

Dis­claimer:
Opin­ions expressed in this mate­r­ial and our dis­closed posi­tions are as of April 9, 2010. Our opin­ions and posi­tions may change as sub­se­quent con­di­tions vary. We are a fee-only invest­ment advi­sor, and are com­pen­sated only by our clients. We do not sell secu­ri­ties, and do not receive any form of rev­enue or incen­tive from any source other than directly from clients. We are not affil­i­ated with any secu­ri­ties dealer, any fund, any fund spon­sor or any com­pany issuer of any secu­rity. All of our pub­lished mate­r­ial is for infor­ma­tional pur­poses only, and is not per­sonal invest­ment advice to any spe­cific per­son for any par­tic­u­lar pur­pose. We uti­lize infor­ma­tion sources that we believe to be reli­able, but do not war­rant the accu­racy of those sources or our analy­sis. Past per­for­mance is no guar­an­tee of future per­for­mance, and there is no guar­an­tee that any fore­cast will come to pass. Do not rely solely on this mate­r­ial when mak­ing an invest­ment deci­sion. Other fac­tors may be impor­tant too. Invest­ment involves risks of loss of cap­i­tal. Con­sider seek­ing pro­fes­sional advice before imple­ment­ing your port­fo­lio ideas.

Richard Shaw
QVM Group LLC

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