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Rule #1: There are no rules.

The Stock Game

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I have a new form of entertainment in my life: stock trading. I’ve been watching the markets for a few weeks, and I made my first trade on the 16th, purchasing MLS when it was low, and riding it up. My investments have been very small thus far—roughly $1000. While that’s not exactly pocket change, it’s difficult to get away with much less. Assuming a brokerage fee of $13 (E*TRADE’s basic price), which has to be paid on both on your buy and sell order, you’ll need to earn 2.6% (= 2 * $13 / $1000) on your investment just to break even. 2.6% percent isn’t a tremendous amount, but what if you discovered a mechanism whereby you could (near-)consistently make 0.5% on your short-term trades? You could make quite a bit of money over time, except you’d be destroyed by brokerage fees. But if you invest more than $5200 (= 26 / 0.5%), then your low gain percentage strategy can still work.

So far I am a member of the camp which says that in the short-term the market acts more like a voting machine than a weighing machine. In other words, while we sometimes look at the market as a reflection of the health of a company, there is actually a strong human element affecting the price of a stock. The confidence of investors in the health of a company is the most important fact, not the actual health of the company. That said, it is the job of a short-term trader to predict how other investors will react to the market, and to use those predictions to eir advantage.

Some argue that the behavior of the market is so erratic as to be essentially random. If the market actually is random, then we have a 50% chance of making money. We invest, and half the time it goes up, half the time it goes down. That’s based on investing and simply selling consistently at some fixed interval after the investment time. Not very realistic because usually we would not cash out at a low point, but we would cash out at a high point, but let’s use it as a model.

Of course the market is not truly random; it’s values are the product of something (maybe mostly human opinion, maybe mostly economic factors, who knows), but what we really care about is our ability to predict future values. The market might have the appearance of randomness, perhaps like a chaos system. Let’s assume that the average investor experiences 50% success (and therefore breaks even). If we wish to make money, “all” that we need to do is gain a slight advantage over our competitors. We need to beat 50%. More precisely we need to beat (BROKERAGE RATE * 2 / INVESTMENT AMOUNT) + 50%, or 50.5% for our example $5200 investment with $13 fees. Seems possible, right? So the question becomes ‘how do we boost our odds?’

I’m sure there are many ways you can gain a slight advantage. The most obvious is education. Gain a better understanding of how the market works. Watch the market and amass knowledge of it’s behavior. Read what resources you can find. Surely you can gain an edge from education (besides, the word ‘education’ has ‘edge’ built right into it…surely that means something good ;)). The second means is to use technology. I spend a great deal of time watching Google Finance. Why? Because the charting capabilities are awesome, and because it plots relevant news events on a timeline. Sure the quotes are delayed twenty minutes—I have to watch a real-time quote source as well—but the ability to easily see how the market reacted to news makes me a more informed investor. Also consider that some portion of the investor population only uses the newspaper to monitor their investments. And that leads me to my final method for gaining an edge: watch the market constantly! I’m usually at work for the hours the market is open, so I keep a stock ticker on the top of my screen. If the market rises to a nice sell point, but then falls again in a span of time when you weren’t watching it, you missed a great opportunity. Not everyone watches the market constantly, so take advantage of that.

Now, a couple corrections to what I said above, because it was definitely a simplification. First, my 50.5% math is a little bogus. Some portion of the activity on the markets is the result of full-time, highly-educated investors. I don’t know what fraction this represents, but if you know, please inform me. This will push your starting point below an even 50%. Second, I wouldn’t expect a uniform distribution of investors’ market successes, so to say that you beat 50.5% percent of investors doesn’t precisely say that you made 0.5%, but it still might be a useful heuristic for average cases. My suspicions are that the 50% model is accurate enough to be useful.

Closing thoughts: it’s far from a sure thing. Don’t say that I said it was it was a sure thing; I didn’t. In fact, I think there’s a 50% chance you will fail (at least until I know more about who you are). I’m not an expert, I’m a 22-year old computer scientist trying something new and offering my speculations. Don’t invest money you can’t spare in something as volatile as your stock picks. Even neglecting the fact that you might lose it (duh!), your fear of losing it will cause you to make less rational, less calculated decisions than someone we is investing spare income. You’re giving your opponents the edge. And if you don’t believe me, ask a poker player about that.

How am I doing? Well, so far I’m up 11.5%. That’s an amazing return for nine days’ work. But it’s a small sample set. I’ll report back later. In any case, it’s a lot of fun. Certainly better than an MMO, IMHO =). I actually enjoy waking up early to check the market, and that is unique for a college student.

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