Lessons From Sun Tzu's The Art Of War For Your Trading

Applying Sun Tzu's Art of War to 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.

Courtesy of Alvin Chow, bigfatpurse.com



