The stock market is a forum for debate between buyers and sellers on the values of companies. That is the nice explanation. The reality is that the stock market is a war between buyers and sellers, who each want to take the others money. The stock market is rough, and if you don't approach it with the disposition of an irritated general, you will lose. In the stock market, nice guys finish last.
Sun Tzu's, The Art of War serves to highlight many aspects of trading, since trading the market is much like warfare. Here are some quotes from the book, and their application in trading:
"All warfare is based on deception."
Suppose you are a large hedge fund, and you want to accumulate a stock. You know that taking a sizeable position will move the stock higher, and you will end up paying higher prices as day traders jump in to the frenzy. With shares on the books already, you can afford to sell a little bit and paint the chart with a negative technical set up that should entice some selling pressure from nervous retail investors and overzealous short sellers. That selling pressure will help you fill your larger buy order.
You may also bring your buying in phases. Let the stock fall back and trigger stops, shake out nervous investors and free up stock to build the position. You may post fake orders in the Level 2 screen to make traders believe that there are large sellers and add further worry among the uncommitted buyers.
As a trader, you have to be able to differentiate between deception and the true intention of large investors.
Further words from Sun Tzu:
"Therefore, in your deliberations, when seeking to determine the military conditions, let them be made the basis of a comparison, in this wise:
(1) Which of the two sovereigns is imbued with the Moral law?
(2) Which of the two generals has most ability?
(3) With whom lie the advantages derived from Heaven and Earth?
(4) On which side is discipline most rigorously enforced?
(5) Which army is stronger?
(6) On which side are officers and men more highly trained?
(7) In which army is there the greater constancy both in reward and punishment?"
Let me translate this in to stock market terms:
Among buyers and sellers, the side who will gather the greatest profits will be determined by:
(1) Which side believes that the stock market is always right?
(2) Which side is led by the largest investors?
(3) Who is trading with the trend?
(4) On which side is discipline most rigorously enforced?
(5) Which side has more money?
(6) Which side has the best understanding of fear and greed, and how the crowd behaves when pressured by either?
(7) Which side lets profits run, and limits losses?
"According as circumstances are favorable, one should modify one's plans.
We should only add to winning positions and never average down on a loser. Profits are carried by momentum, and if you are on the right side of momentum, you can make a lot of money. When losing, stick to the plan and exercise stop losses. When winning, increase position size as new entry signals are confirmed.
"When you engage in actual fighting, if victory is long in coming, then men's weapons will grow dull and their ardor will be damped. If you lay siege to a town, you will exhaust your strength."
If the expectation of your trade is not working out in a timely fashion, then you have read the market wrong and it is best to exit the position.
"It is only one who is thoroughly acquainted with the evils of war that can thoroughly understand the profitable way of carrying it on."
If you think the stock market is fair, quit trading immediately.
"Hence the saying: 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 to every battle."
If you know the market and know yourself, you will consistently profit. If you know the market but not yourself, your success will be random. If you do not know the market or yourself, you will consistently lose money. Success in the stock market is not just about the market, it is also about knowing how you react to fear and greed.
"The onset of troops is like the rush of a torrent which will even roll stones along in its course."
The trend is your friend.
"The good fighters of old first put themselves beyond the possibility of defeat, and then waited for an opportunity of defeating the enemy."
Good traders know that they can consistently make money, and that confidence fuels them to consistently make good decisions.
"To lift an autumn hair is no sign of great strength; to see the sun and moon is no sign of sharp sight; to hear the noise of thunder is no sign of a quick ear."
Great traders see more than the obvious.
"There are not more than five primary colors (blue, yellow, red, white, and black), yet in combination they produce more hues than can ever been seen."
Keep stock trading simple. You need only understand support, resistance, optimism, pessimism, price volatility and abnormal behavior.
Now that June is behind us, I expect that trading activity will improve. The last month of the quarter tends to be slow because there is not much to drive share price. Now that we are in July, the announcement of corporate earnings should be a catalyst for trading action. Alcoa is the first of the big companies to announce, their earnings are out tomorrow.
The run higher in stocks over the past week was a bounce back from oversold conditions and not a sign of optimism. The major market indexes are now at the point where they could turn from pessimism to optimism. Whether that happens or not will depend on earnings.
Fear is not a big factor in the market, although there are still big issues in Europe the market does not seem to be too concerned. The focus now will be on corporate earnings and whether the US will do another round of quantitative easing.
Comments out of the Fed on Friday opened the door for more stimulus. After another weak jobs number, the Fed has the incentive to act, it is just a question of whether they believe acting will make any difference. As Ben Bernanke has said, it is a question of cost and benefit.
No features this weekend, I would like to see what happens with the market indexes next week before I make any new commitments to stocks.
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