Pull the weeds

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, pull them and plant some more. Do this relentlessly and you will end up with a garden full of blooming flowers.

How do you pull 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 (hardcore) traders use “The 2% rule”. The 2% rule means you are prepared to risk a maximum of 2% of your 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 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.
• Once in profit, some people use "partial stops", they continue to identify levels or technical sell signals and either sell all or part of the position depending on what level or signal is hit.
• 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 the 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 don’t understand volatility you are trading every stock as if it has the same risk, and clearly, there is a big difference between trading Telstra (ASX: TLS) and trading Zip Co (ASX: Z1P). It's easier than it sounds.

Ultimately 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, to set your stop loss levels early, to set them for each individual stock and stop thinking in terms of “the greater portfolio”.

I suggest you read some trading books – the foundation stuff that takes you ahead of the average punter in terms of trading discipline. Most good trading books are very hard work (dull) and full of theory. And they often, interestingly, have nothing to do with picking stocks but are about risk management.

But the early realisation will be that "It's not what you buy, it's all about what you do after you buy". 

Managing the investment, not making it. Most high (low) brow investors working off Buffett quotes have been brainwashed to think it's all about choosing what to buy. For a trader its all about what you do after you buy. That’s the bit that needs a plan and discipline and vigilance and where almost everyone goes wrong and doesn’t bother.

If you are one of those "Set & Forget", Buffett quoting, ineffective "Invest as if they are going to shut the market for ten years" investors, shut your eyes, exercise your first stop loss, and see what happens. You will instantly move from confused, indecisive and unfit to invest, to something...better.

Forever. 

It's not hard. Try it.

Marcus Padley and Henry Jennings are the authors of the Marcus Today Stock Market Newsletter established in 1998. For a free trial of the Marcus Today newsletter, click here.

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