The life of a trader is not what most of us might imagine it to be – ie. glamorous, exciting and paved with gold. More likely it is solitary, private, a bit boring and when done right, provides a living.

We could all be traders.

We could all be Arnold Schwarzenegger too.

Go to the gym every day, lift heavy weights, eat protein shakes, avoid chocolate, and talk in a vague middle-European accent. But the reality is, who can be bothered?

And 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 of the core principles of the job, principles that apply not just to traders but to investors as well, principles like “preserve your capital” and “cut your losses”. Clichés all, 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 being 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 the losers are just as important as the winners and you need to protect against them. To do that you have to pull the weeds and plant flowers in their place. And if flowers turn into weeds, cut them and plant some more. Do this relentlessly and you will end up with a garden full of blooming flowers.

How do you cut weeds? Simple. Use stop losses. How? Let’s cut to the substance.

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

Requirements: Forget the concept of “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. 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 five 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 (hard core) traders use 2% – that is to say they risk a maximum of 2% of their trading capital on any one trade. In other words, on $100,000 of capital (a portfolio of $100,000) they would cut a trade that makes a $2,000 loss. Notably this is not the same as a 2% drop in share price. If they have put $10,000 of the $100,000 portfolio in the trade it could be a 20% loss on that one trade ($2000 of the $10,000).

Another way is to set stop loss levels is by reference to a chart rather than a percentage. For instance if you are 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.

Then there are rolling stop losses. As prices rise you raise the stop loss to guarantee a profit if the price then falls from its new high.

Others set stop loss levels with reference to the volatility of the stock. Setting stop losses at a level that allows the trade to develop without being stopped out by a normal fluctuation. The way to avoid this is to learn about volatility and average true range (ATR). Simply put this means accounting for how volatile a stock is when setting a stop loss. Volatile stocks need more room to move. If you are trading a volatile stock then the ATR will tell you and you can set your stop losses a bit further out. And if you find yourself setting very wide stop losses because of the volatility and you are uncomfortable with the loss the stop loss might imply then you are trading the wrong stock. 

(ATR - Average True Range - First of all you calculate the "true range" which is the greater of the difference between the current period high and low, the current period high and the previous close or current period low and the previous close. To get the average true range you take the average of the true ranges each day over a set number of periods (usually 14). The result is expressed in cents and suggests that this is how much a share price can move in a day. So if a 300c stock moves 10c a day you might set your stop loss initially at two ATRs from the purchase price...ie at 280c.) 

There are a lot of ways of setting stop loss levels. As noted, a flat percentage is very basic. But the core to it is to make the decision to use them rather than rely on guts, set your stop loss levels early, set them for each individual stock and stop thinking in terms of “the greater portfolio”.

Of course all of this takes a bit of monitoring and this is where most of us fall down. But it is not as complicated as it might seem.

All you need do is get a list of your stocks, a list of current prices and next to that a column defining your stop loss levels. Every so often update the current prices and compare to the stop loss price. It’s that simple.

If you consider yourself a long-term investor and your concern is Armageddon rather than a correction, you can be a bit relaxed. Set your stop losses nice and wide and update current prices once a month or whenever the news “vibe” suggests something could be going wrong. Dance to your own tune.

If you are more concerned about short-term fluctuations check in more often. Hard core traders use live prices. The average trader would check against daily closing prices. Other investors might check stop losses against weekly prices.  Whatever suits.

But the main thing is to pay at least some attention to what’s happening and have an understanding with yourself that you will take action when a price falls a pre-determined amount, and stick to your guns.

If you work stop losses diligently then when the market falls over you will find you have sold each stock on its own lack of merits as it turned down and have ended up in cash, where you should be, without having to make some impossibly big call on all your holdings (your portfolio) at once.

Yes, you will make mistakes. Yes, you will sometimes sell stocks that then go up again. But nine out of ten stocks that are going down are going down for a reason and are likely to keep going down. And if they don’t, don’t worry about it. The game is to learn what works and whatever you do it has to be better than setting and ignoring.

Cash is power, taking a loss puts you in the eye of the storm, gives you clarity and you know, you can always buy back.

This is a huge subject to consider 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 author of sharemarket newsletter Marcus Today. For a free trial, go to www.marcustoday.com.au