Lessons From Sun Tzu's 'The Art Of War' for Trading

Sun Tzu's Art of War is a classic piece of work that is widely read and applied to many fields, due to its fundamental nature that is highly adaptable to many areas of our lives.  In this post, I extracted parts of the work and applied to trading and in doing so, hope to introduce the important trading concepts to you.  I have also grouped and categorized them for easy understanding.

To put it in the context of trading, I have rationalized the following terms:
- General = You, the trader
- Battle = Trading the market/making a trade
- Men, Soldiers = Your capital, dollars!

ON WINNING IN THE MARKET

"Now the general who wins a battle makes many calculations in his temple ere the battle is fought. The general who loses a battle makes but few calculations beforehand. Thus do many calculations lead to victory, and few calculations to defeat: how much more no calculation at all! It is by attention to this point that I can foresee who is likely to win or lose."

Calculations are to be made prior to any trade. What is the risk-reward ratio? What is the stop loss level and the amount that I am willing to lose? What is the size of position to take? How much leverage can I take? If the price moves to $XXX, what action should I take? What is my price objective? What is the probability of winning? These are just questions that need to be answered and determined BEFORE a trade is made. THE BATTLE/TRADE IS WON BEFORE IT IS FOUGHT/MADE.

"If you know the enemy and know yourself, you need not fear the result of a hundred battles. If you know yourself but not the enemy, for every victory gained you will also suffer a defeat.
If you know neither the enemy nor yourself, you will succumb in every battle."

This is a phrase commonly quoted. In trading, it is true that you need to know yourself. It includes understanding your psychology and how you behave or react to profits and losses. The enemy in this case is the market. You need to understand the market before you do any form of investing. You need to take time to understand the market, ensuring yourself to have an edge over the rest of the investors. With a good understanding, you can design and use a system to capitalize on market movement. In addition, you will be able to apply the correct tactic to beat the market. If you do not know the market and you do not understand yourself, it is likely you will end up in losses.

"To secure ourselves against defeat lies in our own hands, but the opportunity of defeating the enemy is provided by the enemy himself."

As a trader, you need to protect your trading capital and abide to the rules of your trading system for entries and exits. Once you ensure you have done your part, the amount of profits or losses will be determined by the market. You have no rights to ask for any amount of profit from the market. Even if you followed all your rules strictly, it is possible you can lose but you have to accept it and move on.

"What the ancients called a clever fighter is one who not only wins, but excels in winning with ease. Hence his victories bring him neither reputation for wisdom nor credit for courage. He wins his battles by making no mistakes. Making no mistakes is what establishes the certainty of victory, for it means conquering an enemy that is already defeated. Hence the skillful fighter puts himself into a position which makes defeat impossible, and does not miss the moment for defeating the enemy."

To trade correctly is to follow a system or a set of rules. The converse is true, making a mistake means the trader did not abide to the system or the rules when making a trade. The trader does not follow the rules because he is affected by his emotions, which are in turn swayed by news, recommendations, and comments of the others. To win in the market, traders must strive not to make mistakes, i.e., he must be able to execute his trades without any people affect his decision making. This is especially so when it comes to cutting losses. A trader who fails to cut loss commits a grave mistake. Because this one mistake can wipe out his gains and his capital. It is very important to position yourself in the market without making mistakes.

"Thus it is that in war the victorious strategist only seeks battle after the victory has been won, whereas he who is destined to defeat first fights and afterwards looks for victory."

A trader enters a trade with certainty that he is favorable to win. He has an edge over the others in terms of probability. He has a favorable risk-reward ratio, such that he risk an amount for at least 2-fold of reward. He knows when to enter and exit. Hence, the victory is calculated before the trade is made. Most untrained investors get into the market without any careful calculation and often end up not knowing how to exit when the market moved.

"In respect of military method, we have, firstly, Measurement; secondly, Estimation of quantity; thirdly, Calculation; fourthly, Balancing of chances; fifthly, Victory."

When it comes to assessing a trade, you must have a pre-determined set of rules or system to help you evaluate (measure) a potential trade. Secondly, you must know your position sizing to buy the right number of contracts (quantity) based on the size of your capital. Thirdly, you must determine the cut loss and profit taking price and calculate the risk-reward ratio to make sure your reward is at least 2 times your risk. Fourthly, you must know what is the probability of winning using your system in the current market condition. Lastly, make the trade and wait for the market to decide if you are right or wrong. 

"Do not repeat the tactics which have gained you one victory, but let your methods be regulated by the infinite variety of circumstances."

Over the long run, market conditions change. The system that works in the past may not be relevant in the new market condition. You must review and fine tune the system when market conditions change. You will know it when you realize you have much more losses than usual even though you abided to the system rules closely.

"A clever general, therefore, avoids an army when its spirit is keen, but attacks it when it is sluggish and inclined to return. This is the art of studying moods."

The central idea of trading revolves around reading the market's moods. Price actions, volume and indicators are signs for the trader to discern the market's moods and the investors' behavior. You will trade well when you can interpret the moods.

"It is a military axiom not to advance uphill against the enemy, nor to oppose him when he comes downhill."

The key to trading is not to fight the trend. When the market is trending up, look for opportunity to long and do not short it. Likewise, if the market is trending down, look for opportunity to short and do not long it.

"The art of war teaches us to rely not on the likelihood of the enemy's not coming, but on our own readiness to receive him; not on the chance of his not attacking, but rather on the fact that we have made our position unassailable."

As previously addressed, a trader must do the due diligence to put himself in a position such that he has a higher probability of winning in the market. You should never have the mentality of conquering the market. The profits are decided by the market and you can never force it.

"The general who advances without coveting fame and retreats without fearing disgrace, whose only thought is to protect his country and do good service for his sovereign, is the jewel of the kingdom."

 The trader must win in the market not to prove that he is right, but to seek profits. When he is wrong, he must cut his losses without feeling disgrace. Only by having this mentality, he can do well for his trading account.

ON UNDERSTANDING THE MARKETS

"We are not fit to lead an army on the march unless we are familiar with the face of the country-its mountains and forests, its pitfalls and precipices, its marshes and swamps."

Like what Warren Buffett says, "risk is not knowing what you are doing." If you do not understand the market, you are not fit to invest in it. You will get your capital (army) wiped out.

"He who knows these things, and in fighting puts his knowledge into practice, will win his battles."

It is not good enough to know theories and concepts behind investing. A trader must be able to apply the knowledge correctly to profit from the markets.

"He who knows them not, nor practices them, will surely be defeated."

 If he does not know, and not apply the correct trading techniques, he will definitely lose in the markets.

ON YOUR PSYCHOLOGY

"The general, unable to control his irritation, will launch his men to the assault like swarming ants, with the result that one-third of his men are slain, while the town still remains untaken. Such are the disastrous effects of a siege."

Do not be emotionally affected by the market or your losses. If you are too eager to gain profits or revenging a loss, you lose your sanity and become irrational. The decision-making is likely to be flawed and probably ending up with losses. Re-writing the statement, "The trader, unable to control his irritation, will launch his capital to the assault like swarming ants, with the result that one-third of his capital are slain, while the profit still remains untaken. Such are the disastrous effects of an impulsive trade."

"There are five dangerous faults which may affect a general:
(1) Recklessness, which leads to destruction;
(2) cowardice, which leads to capture;
(3) a hasty temper, which can be provoked by insults;
(4) a delicacy of honor which is sensitive to shame;
(5) over-solicitude for his men, which exposes him to worry and trouble"

Psychology is key to a trader. If he cannot control his emotions and character, he will lose in the market. If he is reckless, he will make rash trades without calculating his odds of winning. If he is a coward, he can never win big enough to cover his losses. If he has a hasty temper, he will try to take revenge at the market which end up in further losses. If he boasts when he wins, he will be quiet when he loses and he will never learn from his mistakes. If he is over concern about his losses, he will never be able to trade properly ever again.

ON MANAGING YOUR MONEY

"Sun Tzu said: The control of a large force is the same principle as the control of a few men: it is merely a question of dividing up their numbers."

Trading a large capital is the same as trading a small capital. You should not be affected by the absolute figures of losses and profits when trading a large capital. Follow the system and rules normally and divide a large capital accordingly based on proper position sizing methods.

ON STAYING AWAY FROM THE MARKET

"He will win who knows when to fight and when not to fight."

Opportunities are not always available in the market. There are times that your trading system will not work and it is important to abstain from trading the market. If you insist in trading the market under such conditions, you will end up in a string of losses and deplete your capital unnecessarily. When you are experiencing a string of losses, it is an obvious sign to you to stop trading. Reflect if it is the problem with yourself, or is the system not working under that particular market condition. While undergoing your reflection, stop all your trading activities until you figure out the true problem. You will learn more about yourself, your trading system and the market. This experience will help in assessing when to trade and when not to trade in the future. Not to fight is not cowardice, it is the mantra of "live to fight another day".

"If fighting is sure to result in victory, then you must fight, even though the ruler forbid it; if fighting will not result in victory, then you must not fight even at the ruler's bidding."

Learn to trade when it is favorable to do so. But it is even more important to learn not to trade when situations do not permit.

Hope you found this useful

JB

Did the Bank of England Just Kill the QE Trade?

In case you missed it, something of major import occurred today. As mentioned on the sky website (and a few others)

That something is the Bank of England announcing that it is suspending its QE efforts because of questions relating to its "potency."

This is a heck of a statement from a Central Bank. And it's coming from the one that has even outdone Bernanke's QE efforts.

Since the crisis began, the BoE has announced QE efforts equal to $598 billion. The UK's GDP is $2.43 trillion. So the BoE has engaged in QE equal to over 20% of the UK's GDP. By way of comparison, the US Fed has announced QE equal to about 12% of the US's GDP (I'm not counting Twist here).

Despite this massive amount of QE, 2.53 million people are out of work today in the UK, up from 2 million at the start of the Great Crisis in 2007. Similarly, the UK's GDP remains well below its peak.

In simple terms, QE fails to generate economic growth or jobs. End of story. The BoE spent 20% of the UK's GDP on QE (a truly staggering amount) and more people are unemployed now than when it started. And GDP has yet to get even close to its pre-Crisis highs.

And yet, the US Federal Reserve continues to believe that QE is the answer to our economic prayers. At this point they're not only ignoring history, but they're ignoring real world examples (the UK), which show that QE fails to aid the economy or jobs in any meaningful way.

Meanwhile, the cost of living continues to spike around the world. Workers have demanded wage hikes everywhere from Chicago to Germany to China. Food prices continue to rise as does energy.

There is a word for this... it's called stagflation. And it never ends well. Which is why I strongly urge everyone to prepare for tings to get much much worse before they get better.

Fundamental Recap = Implosion!

The Obama Administration has won its second term. And now that the election is over we can come to grips with the fact that nothing has been fixed and that the math is impossible both in Europe and America.

First and foremost, Greece is out of money... again.

The country is currently embroiled in a new 48 hour strike to protest the next wave of austerity measures which will be voted on today in order for Greece to qualify for the next round of bailout funds.

The bailout in question, €31.5 billion, was actually due five months ago but was not paid as Greece has failed to meet budgetary requirements. Without this money the country will run out of funds by November 16. We'll see how this pans out but suffice to say the same issues (Greece is broke and will remain in the EU as long as it gets money) are still in play. None of them are good.

Then of course there is Spain, which continues to present impossible ideas to deal with its impossible economic situation. The country currently has just €37 billion in cash lying around. With this, it somehow plans on buying €60 billion worth of bad bank assets.

This is doable over time... provided that Spain doesn't have a single other problem occur. Unfortunately, we're up to five regions requesting bailouts leaving just €3 billion in funds available for any other regions that face a shortfall (there will be more).

Meanwhile, Spanish banks continue to draw over €400 billion from the ECB... up from €300+ in June. And on top of this, the country needs to raise €207 billion next year while keeping rates low.

And then of course there is the US...

The US re-entered recession in June 2012. They are now facing the fiscal cliff again with the threat of tax hikes hitting in early 2013. They also have $16 trillion in debt and are running our fourth $1+ trillion financed by the US Federal Reserve which bought over 70% of all US Treasury issuance last year.

Speaking of the Fed, Obama's win means Bernanke's job is secure (boooooooo) at least until he decides he wants to step down... which if he has any sense he'll do so that the disaster waiting to unfold can happen on someone else's watch.

That someone else will likely be Janet Yellen, (ie, even worse) the current Vice Chair of the Fed, who is an even bigger dove/fan of money printing than Bernanke (she said that QE 3 would "benefit the world," a truly staggering claim given the increase in inflation both in the US and especially in emerging markets).

What does this mean?

Simple... the very same problems that the world faced on November 5, 2012 remain in place. And we now know that those in power (Bernanke and Draghi) favour money printing over everything else. 

So the cost of living/ inflation will continue to rise and the world will lurch ever closer to the great debt implosion that will eventually take down the financial system.

Happy thoughts indeed, Happy trading, and STAY SAFE!.... time to go buy some gold....

Daily Equity Future Overview

Equity futures overview The S&P500 futures ended with losses last week after trading below the 1400.00 level on Thursday and Friday, though we did close above here.

My Thoughts from the Trading Floor
	Equities still weak Equity markets remained on the back foot last week as we closed lower again. Thursday and Friday saw the Spoo futures trade below the 1400 area for the first time since the beginning of September, making a low at 1394.50. We did close above here but are back around that level this morning. This was good support throughout August and has worked again so far. The bulk of the losses came on Tuesday which was a continuation of Friday’s moves after Monday’s pause for thought. Earnings have dented confidence despite slightly better than expected US growth figures released last week. Hurricane Sandy Hurricane Sandy is expected to hit the East Coast this week and of course any significant damage and disruption this causes is likely to have a negative impact on equity markets due to the lack of economic activity in the NYC area and the potential cost of any clean up. How bad this will be we can only determine in the coming days. This is also likely to lead to much lighter volumes than usual though. Floor trading is closed on Monday and this could well extend to later in the week. Be careful when trading as the algo’s have a field day amongst lack of real liquidity!! Lots of data this week Plenty of data is out this week with all eyes again on the unemployment numbers out of the US (this is the last reading before the election). On top of this we have ISM data as well European PMI’s. The strength or weakness of these numbers should drive the general price direction over the coming two weeks. End of the month Wednesday sees the last day of the month which traditionally causes a sell off going into the close of both the European and US cash market closes so keep an eye out again. Last month the FTSE and Dax both did around 30 ticks in the final few minutes of cash trading, while the Spoo futures sold off a couple of handle before coming right back. If we do see a sell off into the close expect a strong day on Thursday. Technical Oulook 1394.50-95.50 was good support throughout the end of August and it also stopped the sell off last week. This is the key area below though there may also be some responsive buyers around 1387.50-88.25 while 1391.00 represents a high volume area for the December contract. If we do continue to see weakness then there is a major support area around 1369.00-76.00. If 1391.00 and above continues to support the market then we should see a bounce up to 1411.25-12.75 at least, with an eye on 1420-25 further up. Important events this week     Monday: US Core PCE     Tuesday: DE Unemployment, EU Consumer Confidence, US Consumer Confidence     Wednesday: US Chicago PMI     Thursday: UK PMI Manufacturing, US ADP Employment, Initial Claims ISM Manufacturing     Friday: EU Manufacturing PMI’s, US NonFarm Payrolls Bull View The market did bounce of precious support at 1394.50-95.50 and from here a move back up towards 1411.25-12.75 could materialise. A test of 1420-25 would be the main target. Bear View The bears remain in short term control; another test of the recent lows would put more pressure on the market and open us up to testing 1391.00 (high volume area) and then 1387.50-88.25.

GBP / AUD Long?

Is it time to buy GBPAUD?

Currently long NZDCAD, I am casting my eye over GBPAUD and it seems to have reacted nicely to a decent soft level of support....one which has been well respected in the past.

Fingers and toes crossed it doesn't run away before the end of today, for a long trade. Even though it is not completely at the bottom of a long term range, it is at a level which has been quite reactive in sending price action on its way to the top of its range in the past!

Gets rejected off this level often, and the indicators are showing divergence as indicated by the arrows i drew on...

Fellow traders, any thoughts?


Generally i'd be looking for a reversal pattern either on the Daily or a confirmation on a lower time frame for tighter entry, but this does look good to just 'jump in whilst the water is warming up'