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Stop loss orders
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?

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. 

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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