Disciplined Investing

Another low volume rally on bad news today, and this means that the last two weeks have seen me giving up about half my gains for the year, which is a bit of a bummer. I could make arguments that this is a BS rally or that markets are irrational, but if you're a trader/investor, irrationality is something you're attempting to exploit. That's the point.

Most of my trading is reactionary based on pre-determined rules. If the market does X, I buy Y. If Y does Z, I either sell or hold based on a pre-determined set of rules. This system had me losing money from S&P 760 to 666, but then allowed me to make a lot of money (by my standards, at least) on the first few stages of the rally up until about S&P 800. Since then, I've grown bearish, and been smacked upside the head for my troubles.

I don't use tight stops on many of my trades. Instead, I use other forms of risk management, such as a paired trade. For example, I went long Chinalco (ACH) at around 11. This stock has gone as high as 21, and has hovered in the high teens generally. Since then, I've added a short Baidu (BIDU) at 180 to hedge the downside risk. This has kind of exploded against me, as BIDU is around 225. Now, I think most investment professionals would have sold by now. I remain bearish on BIDU and long-term bullish on Chinalco. Gun to head, I think BIDU falls below 100 by January 2011, and that Chinalco will fall below 10. But I don't know for certain what either will do. So I'm comfortable owning Chinalco, which has a Price-to-Sales ratio of 1, while shorting BIDU, which has a price-to-sales ratio of over 15, even though the trade is going against me bit right now.

Could this decision cost me all my gains in Chinalco? It most certainly could. But a more likely scenario is that this rally peters out, BIDU hits a brick wall, I sell BIDU way lower, use it to buy more Chinalco and eventually the big bad Chinese aluminum company rakes it in big time. This is a happy scenario for me, but I think it is likely enough. And if I'm wrong, I'll probably only give back the gains I already made.

Sounds like a decent risk/reward to me. In a world where I'm not using stops (at least on this trade -- I use them on others all the time), this is just one example where disciplined trading can be different from setting tight stops.

Now, if my entire P&L for the year starts to run away from me, then I will re-evaluate and get smaller. But we're not there yet...