The Hindu Business Line : War tactics for the markets

Daryl Guppy offers The 36 Strategies of the Chinese for Financial Traders to help overcome your two biggest enemies in the markets. Vijay Singal provides tips on `stock market anomalies and low-risk investing' in Beyond the Random Walk. And Stephen Frey weaves a plot around the high-stakes game in The Power Broker. Three weekend reads D. MURALI recommends to kick-start September.

After trawling through ancient wisdom to gain trading insights, Daryl Guppy returns from the Dragon Land with The 36 Strategies of the Chinese for Financial Traders (www.wrightbooks.com.au). "A compilation of political and military strategies dating back more than 1,800 years," says Guppy about the book.

You may need all the help that he offers because when you trade there are two powerful factors against you. "The first is the market itself. It is the most skilled and audacious pickpocket in the world. In the blink of a computer screen the market can remove thousands of dollars from your trading account," cautions the author.

Which is the second force against us? Other traders. "Make no mistake, we trade against some of the best and most intelligent minds in the world," alerts Guppy. "By not underestimating our opponent we give ourselves a better opportunity to survive." The book presents the strategies in two groups, viz., of advantage and disadvantage. In the former, `you have the luxury of time and resources.' Not so in the latter.

Unlike war, there is no `total victory' in markets. "There is never a total defeat and subjugation of the enemy. Every day the trading challenges continue in an ongoing battle. Our objective is to remain consistently profitable," explains the author. "Real trading reduces academic theories to tatters as the market creates conditions that challenge theory and practice." The trading terrain has `greed and emotion' unfettered. Rather than think that the fittest who survive do so with `lightning-fast reactions', you can lift your heads `above the skirmish activity in every trade and focus on the wider context of your relationship with financial markets,' assures Guppy.

The first, in the set of six `advantageous strategies,' is `deceiving heaven to cross the sea.' Explanation of this, on Wikipedia, reads thus: "To lower an enemy's guard you must act in the open and hide your true intentions under the guise of common every day activities." Put aside the fears and focus on `those elements of everyday events that hold the key to market success,' interprets Guppy. For example, use rights to earn almost risk-free return, he advises. This is how: "The trader dips into his existing shareholding, selling an equivalent number of shares to his rights entitlement. He replaces these sold shares with shares from the rights issue at a lower price. This is arbitrage short sale and may deliver a 10 per cent to 15 per cent profit."

The second strategy is to besiege Wei to save Zhao. "When the enemy is too strong to attack directly, then attack something he holds dear," informs http://en.wikipedia.org. That is, `attack in areas which are least expected,' says Guppy. "Find opportunity in areas overlooked by the more traditional investors and by the large institutions." That way, you can hope to grow profits `at a faster rate than the market'. But take care not to attack too soon. "Develop the patience to wait for proof a trend is changing and then launch an entry."

By now you should be bold enough to go for `killing with a borrowed knife,' as the third strategy dangerously reads. "Use a third party to do the work while you reap the benefits," as for example through derivative products. "Although derivatives such as warrants may be traded in their own right, they are also a very useful tool for magnifying the returns from the activity of the parent stock." Price leverage is another knife available for the asking, at the lower priced end of the market. Because "it is easier for price to move from $0.01 to $0.02 than it is to move from $0.10 to $0.20."

Next, conserve energy `while the enemy tires himself out.' The enemy for the trader is `the power of a destructive downtrend.' Contrary to the expectations of rebound, there can be sideways movement `for months, or sometimes years'. Guppy counsels the use of a group of moving averages to track `the traders' inferred activity' and to know `when the downtrend is weakening.' That way, you can `conserve energy while the downtrend exhausts itself.'

The fifth strategy is `looting a house on fire', or in the lingo of trading, to go short and thus `exploit chaotic situations that create temporary price distortions'. One example is `an over-subscribed initial public offering (IPO)' because those who have pre-issue entitlements can `stag' the IPO listing on the first day.' Another example is harsh weather, such as hurricane.

Last in the first group of six strategies is `making a feint to the East while hitting out in the West'. In this you confuse the enemy so that he can't clearly assess the developing danger. "Transparent markets, where the order lines are posted for all to see, provide traders with the opportunity to make a feint to the east," one learns. "With access to more exact order details we see the structure of buy orders." You can bet they too are making a feint!

What follow are opportunistic, offensive, confusion, deception and desperate strategies. The last is `escape — the best scheme.' This isn't stop loss, but knowing when not to trade, distinguishes Guppy. "Trading is a demanding activity and at times we are simply exhausted or lose touch with the market. The market becomes an overwhelming force so retreat is the best option." The 36 strategies aren't a way of doing business, clarifies the author in conclusion. "They are a way of thinking about our relationship with the world, with events over which we most often have no real control, other than to decide our reactions. This is the essence of life, and of the market."

Meandering through mispricing

For further help in navigating the market, here is Vijay Singal's Beyond the Random Walk, in paperback from Oxford University Press (www.oup.com). "In an efficient market, all stocks should be valued at a price that is consistent with available information." That doesn't happen always, so inconsistencies show as mispricing. When persistent and well known, such mispricing is an anomaly, explains Singal. And his book is `a guide to stock market anomalies and low-risk investing.'

Before you jump into decipher price patterns and discover new mispricings, the author lists tests to run through. First check if `the mispricing is not well understood.' An example for this is `the weekend effect, first discovered in the 1970s', characterised by the return on the last trading day of the week being highly positive. "It becomes very risky for an arbitrageur to try to profit from a mispricing without knowing why it exists." Another check is whether arbitrage is too costly. For instance, "small stocks have high bid-ask spreads and low liquidity, making the potential benefit insufficient to offset the transaction costs." The book has chapters on topics such as momentum in industry portfolios, mispricing of mutual funds, merger arbitrage, and bias in currency forward rates. The penultimate chapter draws lessons from behavioural finance. "For example, one negative earnings surprise after a string of good quarters is insufficient for investors to conclude that there is a change in the firm's prospects. That evidence must be supported by several instances of bad news before investors will alter their beliefs." Singal, however, wouldn't advise you `to read the market with a behaviouralist's eyes' because "the current set of behavioural finance models do not provide better or more convincing explanations for the anomalous price patterns than the explanations provided by existing models based on traditional finance."

Of immense use is the final chapter on `other possible mispricings', in which are listed, among others: charting ("not a good predictor of future returns"); value line enigma ("simply a manifestation of the under-reaction to earnings announcements"); and momentum and reversal in returns ("25-40 per cent of the future return is predictable based on past returns").

Lot of work to sell well

Take the high-stakes game to the next level, with The Power Broker, by Stephen Frey, a managing director at a private equity firm who had earlier worked in M&A (mergers and acquisitions) at JP Morgan. The novel opens with Christian Gillette watching the landscape from his hotel room in Las Vegas. He runs Everest Capital, "a Manhattan-based investment firm that owned thirty companies in a wide range of industries — smokestack to high-tech." But before you flip through 10 pages, there is the SEC (Securities and Exchange Commission) looking at Central States Telecom and Satellite, one of the portfolio companies, for `accounting irregularities.'

Meanwhile, Gillette explains to Ray Lancaster how the system works. "Big investors front us the money. Insurance companies, banks, pension funds, wealthy individuals. We buy the companies with the money the investors commit to us, operate them for a few years, then sell them, hopefully for a lot more than we paid." Only, when selling companies, Everest would retain twenty per cent of the profits.

"Selling a company for more than you paid takes a lot of work, and almost as much luck," Gillette elucidates.

Market reads to kick-start September with, as a weekend strategy.

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