MANY INVESTORS HAVE

had problems with stop-loss orders at one point or another. Using them in the wrong way can be just as dangerous as not using them at all.

The most common pitfall comes when they become an excuse to persistently follow a weak stock straight down the drain. (A stop-loss order, for those who aren't familiar, is an order to sell a stock at a specific price that's below its current market value.) Although designed as a risk control mechanism, stop-loss orders often facilitate the self-destructive knife-catching that comes when a trade in which you've got a major emotional investment keeps getting tossed. The seductive nature of calling the bottom inevitably means buying and selling the whole way down.

You know the drill: You buy XYZ at $50 and get stopped out at $45. You re-enter at $42 and the stock pops to $44 before heading down to $38 and you get stopped out again. Now the stock is at $35 and you buy more, certain that this time you're really getting a bargain. In almost all situations, it's a bargain you don't want to own.

In effect, that type of technique overlooks what the real purpose of a stop-loss order is: not simply a way to catch a few hundred dollars profit in a trade, but to reallocate assets in the midst of a significant market shift. If a position gets stopped out, it's probably for good reason, mostly addressing the reality that that weakness in the stock has rendered your position as a lower probability for success.

So when I get stopped out, the absolute lowest price I'll generally consider re-entering the trade is exactly the price at which I was stopped out. Until it can at least hold the level at where I last sold it, I'm hesitant to get back into what is obviously a troubled trade.

So let's say you bought XYZ at $50 and got stopped out at $45. Now the stock is at $42 and you're still bullish. I wouldn't even consider repurchasing it until at least it could clear and hold the $45 level, right around where I previously got stopped out.

My belief is that you liked it at $50 because you thought it was going to at least $70. At $42, the stock itself, the strongest indicator we have, is indicating you were at a minimum 16% wrong in your estimate of value. For my money, I'd rather let the stock regain higher prices to confirm my previous bullish thesis before getting back in. At $50 you can love it. But at $42 you should be suspicious as to what's gone wrong. In most cases, sharply lower prices are indicative of a change in trend, rather than just a "blip" on fundamental news.

Of course, oftentimes stops get hit and we are kicked out of trades that later end up as winners. The solution is twofold. First off: Use wider stops. Too often people use stops simply as an excuse to make a trade. If you buy XYZ at $50 and set a stop at $49...it will get sold. Because our objective should be to stay with a trade, it's much better to use a slightly smaller position and set a wider stop, at least 13%, to avoid getting caught in the normal daily range of most equities.

Secondly, because stops should be seen as an opportunity to tweak exposure, rather than simply dump your book, I think using staggered orders makes sense for anybody with a legitimate position of at least 2% of assets. So you buy XYZ at $50 and it falls to $45. Instead of dumping the entire position, consider selling half at $45 and the other half at $44.

I believe the extra $1 loss, which would lower your effective sell price to $44.50 from $45, is a small price to pay for being able to stay in the trade. Essentially, staggering stops allows you the flexibility to maintain some exposure while still reducing your risk in an objectively weak trade. Should the stock rally, you've still got skin in the game and can re-establish your entire lot. Should it break, you've already mitigated some exposure and can exit the remaining shares not far from the initial sell.

The most bewildering element of stops is often how investors will "root against" stocks they've sold, even if their weakness would mean losses in the majority of their holdings.

A client recently mentioned how his portfolio, which was roughly 80% in stocks heading into the summer slump, was rattled with stop orders which brought him down to about a 60% stock, 40% cash allocation. Many of the stocks he sold blue chips mostly were now trading back above where he had gotten out.

He internalizes that reality with anger after all, the stocks he sold should be lower, as to prove he was "right" to get out when he did. The fact that a broad market decline would mean even more significant losses for the substantial 60% he has remaining in stocks is almost irrelevant. He had sold stock and wanted the prices of those securities to be lower, if only to prove to himself it was a "good trade."

Fighting these instincts is exactly why traders should think of stops as a way to shift overall exposure to a market, not to protect a few dollars picked up on any one particular trade.

Jonathan Hoenig is managing member at Capitalistpig Hedge Fund LLC.