Learn when to pull out, or you'll end up holding the baby

We could all be traders.

We could all be Arnold Schwarzenegger too. Go to the gym every day, lift heavy weights, drink protein shakes and avoid chocolate. But in reality, who can be bothered? Who can be bothered to be a trader, because to do it properly is pretty much a full-time job, and most of us already have one of those, and those of us who don't, probably don't want one.

But that doesn't mean we can't adopt some core principles, principles that apply not just to traders but to investors as well, principles such as "preserve your capital and cut your losses. Cliches, but as any trader will tell you, no trading system will succeed without them and no long-term investor will either.

The big mistake for long-term investors is that they see things as part of a portfolio in which the winners make up for the losers. With that mindset, long-term portfolio investors excuse the losers and do nothing about them. But if you really want performance, you need to protect yourself against the losers. To do that you have to cut the weeds and plant flowers. And if flowers turn into weeds, cut them and plant some more. Do this relentlessly and you will end up with flowers.

How do you cut weeds? Simple. Stop losses. Let's cut to the substance.

What are they: An order that automatically closes your trade at a predetermined price, limiting your loss. A mechanism that short circuits debate and emotion and provides certainty.

Requirements: Forget the portfolio. Think of every stock you hold as a separate trade. Preset a stop loss for each individual holding, preferably when you are unemotional and in possession of a clear mind. At the time of purchase would be good but any time will do.

The mechanism: It is impossible to set a rule for everyone. For those of us without trading systems you can use a number of different methods to set stop loss levels. The most obvious is a flat percentage. If it falls by 5 per cent, sell it. But that's very basic and most of us struggle doing that in practice. The market is so volatile these days.

Most (hardcore) traders use 2 per cent . . . that is to say they risk a maximum of 2 per cent of their trading capital on one trade. In other words on $100,000 of capital (a portfolio of $100,000) they would cut a trade that makes a $2000 loss. This is not the same as a 2 per cent drop in share price. If they have $10,000 of the $100,000 in the trade it could be a 20 per cent loss on that one trade.

Another way to set stop loss levels is by reference to a chart rather than a percentage. For instance if trading price breakouts (buying stocks that break a resistance level) the stop loss can be set at the price at which it breaks out and so the resistance level that was broken serves as the stop loss level if it reverses again. Takes a bit of monitoring but you, or your broker, have to expect to do some work here.

Then there are rolling stop losses. As prices rise you raise the stop loss to guarantee a profit if the price then falls. Others set stop loss levels with reference to the volatility of the stock (or the ATR  look it up).

There are a lot of ways of setting stop loss levels. A flat percentage is very basic. But the core to it is to have a plan, set them early and set them for individual stocks and stop thinking in terms of the portfolio. Do that and when the market falls over you will find yourself closing everything out quickly, and in cash without having had to make some impossibly big call on everything at once.

This is a huge subject, so let me leave you with a core tenet: When it comes to controlling losses, anything is better than nothing and if your mechanism doesn't work, you can always change it.

Marcus Padley is a stockbroker with Patersons Securities and the author

of the daily stockmarket newsletter Marcus Today.

www.marcustoday.com.au