I just took part in an online trading challenge sponsored by the National Post and Eriksson:http://www.investmentchallenge.com/traderschallenge-theindependentsplay/challenge_details.aspThe contest ran from 23 October until yesterday and I finished 11th out of about 5,800 entrants with a total return of 32.13% on an initial grubstake of $1 million. The winner had an unbelievable return of 79.5% in 38 days. I actually spent about 4 days in first place, but I sat on the sidelines for most of the last 2 weeks and got rolled over by the frontrunners. There were prizes for the top 15 finishers, and I won a RIM Blackberry pager, which I find very ironic given that I shorted RIM on 5 separate occasions and made $48,000 of my profit at RIM's expense (I also shorted it in real life during this period).If you've followed my recent posts (and former posts as Semper and TWA38), you know I'm primarily a bearish value guy who tries to have a long-term perspective, so what the devil was I doing in a trading contest? Well, I was trying to practice some new tricks with a rigorous accountant to keep me in check.For the record, my definition of investment, as borrowed from Ben Graham, is that which provides adequate return on capital and safety of principle (e.g. margin of safety). My definition of speculation is something that provides above average return on capital coupled with favorable odds. In other words, there's no guarantee that you won't lose money, but rational speculation occurs when the risk/reward spectrum is nevertheless tilted in your favor. Buying lottery tickets isn't speculation, it's gambling, because the odds are against you from the beginning. The time horizons can also be much different: investment = years to decades, speculation = weeks to months, trading = minutes to days. A few things I learned:1) You don't have to be right all the time to make money. I made money on 45 trades and I lost money on 30 trades, so I was only right 60% of the time. Admittedly, that's more than half, but it's a lot closer to coin-flipping than it is to perfection. You don't have to be right all the time provided you…2) Cut your losses short. It's so easy to say, but so hard to do. It's certainly easier to take a small loss with virtual money, so in some respects this was good training. The contest didn't allow stop-loss orders, so I had to monitor positions a couple times a day and bail out if it was moving against me. In many cases, I bailed out at a loss only to have it turn around and move back my way, but you can't count on that happening. I only had 7 losses that exceeded $10,000 (1% of my original capital, or 5% of the maximum position size of $200,000), and in all cases these were situations that moved rapidly against me before I could take corrective action. With strict stop-loss orders in place, my major losses could have been reduced to 0. In contrast, I had 21 positions where I gained more than $10,000, bringing on the next rule…3) Let your winners run. When you enter a profitable position, don't turn tail and run with piddly profits. Protect your profits with a stop-loss (or mental stop-loss in my case), and try to turn your profitable trades into killer trades. One of my problems during the competition was that I had to go on 4 separate cross-country business trips where I couldn't monitor my positions, so I shut them all down right before I left. I was doing very well on several of these, but lost out on opportunities to do outstanding (like shorting Brocade [BRCD] at $261 and riding it down to $241, but missing the rest of the ride down to $150). 4) Hedge your bets by going both short and long. Obviously to make money in the last month I had to have been playing the short side, but at any one time I was about equally short and long. Because my short positions turned over faster, I had about two short positions for every long. I made 33.9% on my short positions and lost 1.9% on my long positions, but if the market hadn't melted down like it did, the longs would have kept me from losing my arse. If you can't/won't go short, then you shouldn't try to speculate, because you'll have one hand tied behind your back relative to your competition.5) Margin cuts both ways. We were allowed to use margin, and everybody who finished in the top 20 was certainly well extended on margin at various points during the competition. But the early leader, a trader named Sylvestre from Quebec who was up something like 45% the first week (!), disappeared from the rankings overnight when the Naz began its first free-fall (e.g., he lost more than 30% on a single day the Naz might have gone down by 5%). My rule was “never be more than 100% long, or 100% short.” When I used margin, it was always to hold about 75% short positions offset by 75% long positions. If I had been 150% long or short on margin, the big market-wide moves would have wiped me out in short order. 6) Bet big, or don't bet at all. I was risking from 10 to 20% of my capital on any given trade. If I was uncomfortable risking that much, it was a pretty good sub-conscious signal that the trade was too risky. I think diversification is fine for investing, and for speculating with real money, but if you're mentally unwilling to risk 20% of your capital on a trade, you probably don't need to risk 2% either.7) Patience is a virtue, even for traders. Even though the competition was only 29 trading days long and I was out of commission for 8 of those because of travel, I didn't trade just because I had capital available. If there was nothing compelling (and I was looking for something where I thought the odds were > 2:1 in my favor), then nothing was often the best thing to do.8) And finally, this ought to be fun! I know it's no fun to lose money, but by the same token, it doesn't do any good to gloat when the market is going sky-high, taking all your stocks along with it. Trading requires a quick admission of guilt when the market proves wrong what seemed like a good idea at the time. Bouncing back from these losses (and learning and adjusting to the mistakes, if any) is probably impossible if you don't have a good attitude about it all. Even though it was only virtual money, punching in the sell order on losing trades (or “buy to cover” for shorts) always hurt at the time, but just like flushing the toilet, it gave me a clean bowl to work with.Good luck all,Todd
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