Seven Secrets of Successful Speculation (Part 1)

by Nicholas Vardy
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The theme of this year's 20th Annual Investment U Conference in Las Vegas was "How to Master the Art of Intelligent Speculation."

In case you missed it, Chief Investment Strategist Alexander Green previewed his keynote speech in Investment U. This week, I want to share my take on the subject of investing versus speculation.

"Speculation" has an image problem.

In 2012, Vanguard founder and index fund pioneer John Bogle published The Clash of the Cultures: Investment vs. Speculation.

The book's recommendation? Don't speculate... invest only in index funds.

Bogle also trashed newfangled exchange-traded funds (ETFs).

Why? Because you can trade ETFs as easily as stocks... and that ability encourages speculation.

I believe both investing and speculation have their place in managing your portfolio.

But you have to be very disciplined in your approach.

Investing vs. Speculation

First, let's define our terms.

"Investing" is buying shares in a company for long-term financial returns.

"Speculation" is trading financial instruments of all types with the hope of substantial short-term gains.

You'll find dozens of books on how to invest like Warren Buffett.

Yet you'll find fewer books on how to speculate like George Soros.

Soros' 1987 book on speculation - The Alchemy of Finance - is virtually unreadable.

And the single most famous book on speculation - Edwin Lefèvre's Reminiscences of a Stock Operator - was published in 1923.

You can study investing in business schools around the world, but I have yet to hear of a business school that offers a course on financial speculation.

This implies that investing is noble and speculation is shady - that's misguided at best... and condescending at worst.

I think you can simultaneously be an investor and a speculator - and be profitable doing both.

Secret No. 1: Financial theory is irrelevant.

Business schools teach modern finance and efficient market theory to explain the rhyme and reason of daily stock market gyrations.

Economists and psychologists have even collected a few Nobel Prizes for their efforts.

Yet the high priests of modern finance have been remarkably unsuccessful at explaining why the market does what it does.

My favorite story involves Stanford professor Bill Sharpe...

In October 1987, a reporter asked him to explain the stock market crash.

His response? "It's weird."

His mother called him on the phone to berate him. "Fifteen years of education, three advanced degrees, and all you can say is, 'It's weird'?"

Sharpe went on to win the Nobel Prize in economics in 1990.

Contrast that with the street-smart approach of speculator George Soros, who has said, "My approach works not by making valid predictions but by allowing me to correct false ones."

Let that sink in for a minute...

The No. 1 speculator in history does not attribute his success to his ability to predict the markets...

His secret is his willingness to admit - and correct - his mistakes.

Secret No. 2: Risk control is critical.

Managing risk is the real secret behind winning - and staying - in the speculation game.

As Bruce Kovner, chairman of CAM Capital, put it...

"In real estate, the key is location, location, location. With money management, the key is risk control, risk control, risk control."

Kovner's primary focus is on what could go wrong.

One of Soros' deputies once said...

"When George is wrong, he gets the hell out. He doesn't say, 'I'm right, they're wrong.' He says, 'I'm wrong,' and he gets out, because if you have a bad position on, it eats you away. All you do is think about it - at night, at your home. It consumes you. Your eye is off the ball completely. This is a tough business."

When former Soros fund manager Victor Niederhoffer ignored these lessons, he blew up his investment firm... twice.

He ended up in so much debt that creditors ultimately took the furniture from his house.

Secret No. 3: Size matters.

The size of your investment, or "bet," is the single most crucial key to surviving - and profiting - as a speculator.

A poker player knows this intrinsically.

If he's dealt a bad hand, he throws his cards away quickly.

If he gets a good hand, he ups his bet.

No wonder poker players often make terrific traders.

The impact of bet size is hard to quantify - but it is massive.

Trading coach Van Tharp writes that bet size accounts for 60% of your trading success.

Exits account for 30%. What you bet on accounts for merely 10%.

You can see the importance of bet size in Soros' biggest trading successes.

Just before September 16, 1992, the day he "broke the Bank of England," Soros famously chided his deputy Stan Druckenmiller for the small bet he made against the British pound.

Urging Druckenmiller to increase his position, Soros said, "It takes courage to be a pig!"

Thanks to Soros, Druckenmiller upped his bet and made $1 billion in a single day in one of the most iconic financial trades ever.

I'll return with the remaining four secrets of successful speculation in Thursday's issue... stay tuned.

Good investing,

Nicholas

Thoughts on this article? Leave a comment below.

A Falling Star Means Rising Returns

"You cannot swim for new horizons until you have courage to lose sight of the shore."
- William Faulkner

That's true of intelligent speculation of all kinds. Just as you leave shore only when you know how to swim, you should speculate in the markets only when you know how to manage risk... and correct mistakes.

Enter Emerging Trends Strategist Matthew Carr to help navigate the choppy waters. In his new Switch Trade Alert VIP Trading Service, Matthew recommends InterDigital (Nasdaq: IDCC) as a profitable put buy now, with the potential to be even more profitable later...

It wasn't that long ago that shares of mobile technology research and development company InterDigital (Nasdaq: IDCC) traded for around $100.

The company relies heavily on patent royalties. And we're starting to see major declines here. In the third quarter, InterDigital's patent royalties tumbled 55%!

And things aren't expected to pick up anytime soon.

Now, InterDigital's upcoming fourth quarter report was tough.

Expectations were for revenue to drop 30% to $191.37 million, with EPS also falling 35% to $2.47.

Well, we know it was even worse than anticipated for InterDigital.

For the fourth quarter, revenue came in at $205.3 million, with adjusted EPS of $2.68. Admittedly, that was better than what Wall Street was hoping for.

But shares of InterDigital tumbled more than 7%, as first quarter revenue guidance was $66 million to $77 million.

And this is exactly what we wanted to see... Those September $70 puts jumped and are now at $4.59! As you know, with put buying, as the stock price falls, the put price rises.

That's a 58.3% gain since I recommended this Switch Trade to subscribers on February 15.

And today, shares of InterDigital are trading around $73 per share.

That's the beauty of this strategy.

Yes, I believe the fastest correction in history that ran from January 26 to February 9 was just the first of many we'll see this year.

Just last month, Morgan Stanley warned that the correction we saw was "the appetizer" of what's to come.

Put buying is profitable when markets are rising - as we saw with InterDigital. But it gets a rocket boost when the market starts to get volatile and rolls over.

And that's what we're prepared for - to score big gains every time the market buckles by focusing on companies whose stocks are poised to drop.

Buy the InterDigital September $70 puts. My Projected Price Indicator believes shares are worth a mere $15.47.

- Donna DiVenuto-Ball with Matthew Carr

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