From the December 01, 2010 issue of Futures Magazine • Subscribe!

The art of war and the science of trading

In most pursuits, be it education, business or sports, we are taught that hard work is the key to success. This is not always so in trading, at least not at first. Most — this author included — experience this firsthand when they launch a trading career. Trading is different. Effort often seems inversely correlated with results if that effort is not spent on preparation.

Indeed, trading success often appears to exist independently of life experience outside the markets. Despite graduating from West Point, excelling in flight school, surviving combat, starting a successful company, raising $50 million in venture capital and taking it public as CEO, this beginner had his butt kicked by his first efforts in trading.

Ultimately, it became obvious that the problem was not the swing trading methodology, per se, but that the initial approach to market analysis was an unworkable fit for the trader. Finding this fit is perhaps the most fundamental ingredient to long-term success. The strategy you adopt cannot run counter to your temperament, goals, experience and risk-tolerance. In the sense that coming to this realization paved the way for a better understanding of what would work, the first year’s $20,000 "tuition" was well spent.

The lessons learned include the following:

  • Trading became a job: It was tedious reading charts for pristine setups, monitoring open positions and continuously tweaking exit strategies – reacting to the latest twists and turns of the markets. While some thrive in this environment and relish the constant analysis, to others it is exhausting.
  • Under-trading: With only two to four trades per month, results were highly dependent on single trades and, therefore, highly variable month to month. This created fear and defensive habits, such as taking profits too soon. With few opportunities to learn from actual trades, learning also was impacted.
  • Overnight risk is stressful: While the investor in you may be able to sleep easy holding long-term positions, the trader side can be rocked by the stress of holding short-term positions overnight. The unknown can be crippling.
  • Trading forward is not as easy as looking backward: We can learn from the past, but we also can’t confuse learning a technique with successfully trading with it. With some approaches, you must predict the direction of the markets twice: at entry and at exit. Some can do this. Some can’t. It’s an art that simply escapes those lacking a certain eye for discretionary chart analysis.


Finding focus

Approximately 15 months of intense effort were invested in a historically viable swing trading strategy, but it never worked. The techniques were valid, but with limited trading skills and a technique that didn’t fit with the trader’s profile, success would have to be found elsewhere. This was a battle for livelihood, happiness and financial security, so starting from scratch, the ancient classic "The Art of War" by Sun Tzu was dusted off. One of the first lines encountered was:

"So it is said that if you know your enemies and know yourself,
you can win a hundred battles without a single loss."

Most struggling traders don’t understand their "enemy" — the markets in this case — but they likely know themselves. Indeed, following a failed attempt, a trader likely has a keen understanding of his trading strengths (say, discipline and math) and limitations (say, impatience, limited experience and an inability to grasp the art of chart reading).

Another key for some new traders is a strategy that trades frequently enough to offer constant input to accelerate the learning curve. Other criteria may be not wanting to trade all day or to hold positions overnight.

This brings us to another line from Sun Tzu:

"Victorious warriors win first and then go to war, while defeated warriors
go to war first and then seek to win."

This single statement has the power to properly focus many trading careers. While many traders conduct extensive analysis to select trades, they are not prepared to win the battle after identifying trade prospects. The mistake is "seeking to win" by counting on chart analysis to determine when to enter and exit each trade. Instead, traders should "go to war" (trade) only when they know exactly how much they can expect to win, how much they must risk and the odds of success. With these three factors, it is possible to calculate profit expectancy and then trade only when this number is in your favor.

More experienced traders may feel this is too simplistic an approach — that more time should be spent reading trading books than war books, perfecting technical analysis techniques.

For some, though, the more direct approach is the better approach — identifying a setup that requires no (or minimal) discretion for entering and exiting the trade. Then, they analyze the historical win rate and profitability of that setup using a wide range of position sizes and stop placements and other variables to zero in on those that had produced strong historical results and avoid those that had not.

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