How Big Of A Sell Stop Should You Use?

My recent posts on the use of sell stops have caused some readers to ask a variety of additional questions. One of them came from Peter, who commented as follows:

First I want to say that I enjoy your blog very much. Recent articles on sell stops have brought up a question that has crossed my mind numerous times. Having used and read about “sell stops,” I would be interested to knowhow you arrive at your limit percentages…..i.e.: (7 percent)?

I have read of investors using anything from 3 or 4 percent to as high as 25 or 30 percent.I have never used a fixed percentage….rather a percentage based on thevolatility (guess work). I would like to refine this approach.

Using sell stops is not an exact science and neither is determining the size of the sell stop. Much depends on the volatility of the investment. I don’t deal with stocks but I now that due to higher volatility compared many mutual funds and ETFs, many investors work with stops in the 10% to 20% range. The exact number for an individual depends on his or her risk tolerance.

For slower moving mutual funds and ETFs in the general domestic and broadly diversified international markets, I use 7%. For faster moving ETFs that are exposed to sectors and countries, I have used 10%.

I know of several independent investment firms that use a flat 8% no matter which type of ETF they invest in. There is no hard and fast rule, except one. You need to give the market some room to move so that you don’t get stopped out at the slightest hiccup. For example, I have had a reader tell me that he was so afraid of losing that he has used stop loss points in the 3% to 4% area.

The result was that they rarely participated in a trend and had deal with constant whip-saws. From experience, I have found that 7% is a good range. It allows some room for market movement and, at the same time, limits my losses to an acceptable number.

For example, if I allocate 8% of portfolio value to a mutual fund/ETF and, if the markets head straight down after my purchase, I will lose around 7% (give or take) of my investment. Since I had only committed 8% to begin with, this means that my total portfolio is only negatively affected by -0.56% or so.

That’s a reasonable risk (to me), however, keep in mind that you may very well have 2-3 losses in a row, which would add up to a higher number. If that type of risk is too much for you, you should not be investing in the financial markets in the first place.