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Stop loss orders |
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Stop loss
order is defined as: an order placed
with a broker to sell when a certain
price is reached. It is designed to
limit an investor's loss on a security
position. This is sometimes called a
stop market order. |
What is wrong with the use of stop
loss orders.
The main reason people lose money in
the market is simply because they do
take too much risk. Take, for
example, the stop loss order rule.
The original idea was to protect
investors from losing money to bad
investments. Sounds reasonable, but
in reality stop loss orders have had a
major impact on how investors
operate. Instead of evaluating
investments based on value, the
concept now is, "Let's just buy it,
and if it falls I will only lose 10%
as my stop loss order gets hit."
Likewise, option players often say,
"Instead of risking $40,000, I will
just put up $4,000 and if I am
wrong, all I can lose is
$4,000."
The problem with this kind of
thinking is that instead of
accumulating gains, you are creating
a system biased toward accumulating
losses, and substantial drawdowns.
So instead
of aggressively going after a stock,
and having to use a stop loss order,
protect yourself by starting small
to begin with.
The use of stop loss orders have
become quite common in the market,
and again it may make a lot of sense
for a short term trader with a high
frequency trading system to utilize
stop loss orders. To the average
investor who is typically in the
market to invest, it makes
absolutely no mathematical sense to
use stop loss orders. You either
like a stock because it's a great
value and are willing to ride the
volatility, or just don’t buy it.
Why would Home Depot be a great
value at $25.00, and a risky
proposition at $20.00?
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Note: the
below "Reallocating a position" could be
mistaken for a stop loss order which I am
strongly opposed to. Keep in mind that to me a
sign of trouble is when a position gets too big,
and not simply a stock price decline.
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Reallocating a position:
I often found that taking a loss at the
first sign of trouble (when you're freezing) is often the
best course of action. Furthermore, if you do
not take the small loss initially, your position
may worsen and you will end up with a much
bigger loss later.
Lesson: If your drawdown increases, and you do not have what
it takes to pull the trigger and make another
buy, reallocate the position.
Suppose you have a stock with a large drawdown
in your portfolio and you are frozen as this
position continues to deteriorate. You
already have
$10,000 invested in this large position and you
are very concerned. In addition, the market
sell off has brought up some good values
that were not available before. What should you
do?
Wouldn't it be better to totally liquidate this
large position and reinvest the money in a
variety of stocks?
Since diversification is the key to my
strategy, what would the effect be if you
liquidated this large position, took a small
loss and then re-invested the funds in 4 to 5
other stocks instead? The same money invested in
4 to 5 other stocks would provide you the
diversification that you currently lack, and an
equal or better ROI when the market rebounds.
The benefits:
1. The large risky position would be
eliminated, thus eliminating the stress and the
risk of a larger possible loss.
2. The funds will be reinvested in 4 to 5 stocks,
further
diversifying your portfolio.
3. The loss from the sale of the large position
will be offset by the gains of the 4
to 5
new stocks.
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