The 36 Strategies of the Chinese for Financial Traders

By Daryl Guppy

Ancient strategies provide a valuable link to enhance your ability to survive and prosper in modern financial markets. In this fascinating book, experienced trader and best-selling author Daryl Guppy explains how The 36 Strategies of the Chinese are applied to trading financial markets. In trading there is rarely a single answer to any trading situation. The best answer, and its effective application, depends on the trader. The strategies by themselves do not guarantee success. The trader’s skill in analyzing and assessing the situation determines how effective he is in selecting and applying the right strategy.

Guppy was introduced to the book of The 36 Strategies of the Chinese by a Chinese friend. An ancient and classic text, it is a compilation of political and military strategies dating back more than 1800 years, drawn from classic Chinese poetry, history, philosophy, biographies and novels.

This book includes specific methods for active investors and traders that are consistent with the meaning of the original ancient strategies. The 36 Strategies of the Chinese for Financial Traders follow the structure of the original 36 Strategies of the Chinese. The first 18 strategies are applied when you have the advantage -- the luxury of time and resources to examine techniques to recognize and maximize the return from these market opportunities. The second 18 strategies are applied when you are at a disadvantage -- they are strategies used against investors and traders to inhibit success. Many of the strategies are enhanced using derivatives.

• Language: English
• Publisher: Wiley
• Release date: Apr 23, 2012
• ISBN: 9781118395578

Book preview

PREFACE

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STRATEGIES FOR SUCCESS

Somewhere between Shanghai and Beijing I realized I had successfully implemented the classic Chinese strategy of Creating Something out of Nothing, closing a parabolic trend trade at a substantial profit. It was a new way of thinking about the way I approached the market and provided a wider strategic context for understanding market activity. Thoughts and impressions that had been developing for many years came together on this flight. My recent work with Chinese financial traders in Shanghai and Nanjing provided the immediate catalyst to combine these traditional concepts with financial market trading. Previously in Beijing and Shenzhen, questions from experienced and aspiring traders in the audience revealed a different way of thinking about the structure of markets and market activity. This book is a more detailed exploration of how these ancient strategies are integrated with modern financial trading.

One of my Chinese friends reviles the book The 36 Strategies of the Chinese. It is tricky she says. It is not honest. It is designed for tricky businessmen. In many ways she is correct. Deception lies at the heart of some of the 36 strategies. But if we look beyond the deception we find the strategies are really about understanding how to gain advantage from situations that at first glance look as if they are tipped against us. The book is about the creation and exploitation of opportunity.

Perceptive viewers of the Chinese film Hero have appreciated the action and application of many of these strategies by the characters in the drama. The 36 strategies lie at the very heart of the artistic appeal of the plot and character relationships. They are essential to the dramatic tension.

This is no quaint Chinese relic. It is a living philosophy studied and applied every day with skill and determination. Some of my Chinese friends automatically apply these strategies every day to protect themselves, to help their friends, including myself, and to prevent others from taking advantage. I can reasonably assume all the Chinese businessmen and women I do business with consciously or subconsciously apply these strategies. The strategies in themselves do not always carry an ethical burden. The use to which they are put delivers the moral and ethical content. These strategies apply when you are under attack, or when you wish to defend yourself by taking offensive action. In the market we are always under attack and we always try to take the offensive to wrest profits from a market that is skilled in withholding them.

The 36 Strategies of the Chinese is an ancient and classic text and has no single author. It is a compilation of political and military strategies dating back more than 1800 years. It is drawn from classic Chinese poetry, history, philosophy, biographies, and novels such as The Romance of the Three Kingdoms. It appears to have been first collated around 400 years ago. Traditionally it has 36 chapters divided into groups of six. These 36 strategies are often said to underpin Chinese business behavior. They certainly provide a framework background against which business is conducted but they are also a foundation of other relationships.

These strategies bear little relationship to the material in The Art of War by Sun Tzu, which contains 13 chapters detailing military tactics and is appropriate for military or war-like situations. It lacks the broader philosophical and political basis underpinning The 36 Strategies of the Chinese. The activity of two Tang Dynasty poets which forms the basis of Strategy 17, Tossing Out a Brick to get Jade, finds no equivalent in the military scenarios in The Art of War.

Some traders view the market as a zero-sum game where there are only winners or losers. Such thinking easily lends itself to military metaphors. The financial market is more complex, with differing conceptions of victory, of winning and losing. Even when it is structurally a zero-sum game as in futures and derivatives markets, there remains considerable room for more sophisticated strategic thinking. The 36 Strategies of the Chinese encompasses the scope necessary to better understand financial market relationships.

As in business, these strategies by themselves do not guarantee success. The trader’s skill in analyzing and assessing the situation determines how effective he is in selecting and applying the right strategy. The 36 strategies of the Chinese are appropriate for financial trading because in trading there is rarely a single answer to any trading situation. The best answer, and its effective application, depends on the trader.

In the financial market we trade against two powerful factors. 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 — unless you are skilled enough to carefully select the circumstances in which you decide to enter and exit the market.

In this sense the market is an implacable, relentless enemy with the capacity to destroy our trading account. We must devise strategies to outwit the market, to defend ourselves against its depredations, and use strategies which throw us into alliance with the market and its returns. The 36 strategies of the Chinese provide solutions for a variety of market conditions. We examine these, and provide case studies to illustrate these strategies.

The second powerful factor we trade against in the financial market is other traders. Most of us are private traders. Make no mistake, we trade against some of the best and most intelligent minds in the world. We cannot know who takes the other side of the trade when we buy a small Singapore company, a mining company with tenements in the remote Australian outback, a technology company based somewhere in California or a manufacturing giant in a Chinese city. The person we buy stock from may be a first-time investor, a full-time institutional trader, a market maker, or a full-time private trader.

We cannot assume the person on the other side of the trade is less intelligent than we are, even though we believe we have made a smart decision to buy. It is safer to assume they know a great deal more than us and that they are more skilled and experienced. By not underestimating our opponent we give ourselves a better opportunity to survive. In this sense, the person on the other side of the trade is always our enemy. We defeat him by making a profit in our trade.

This is a book about trading techniques. It includes specific methods for trading the market, including reading the order line information, understanding the behavior of market makers and integrating news events into price activity. This is not a book about charting or technical analysis, although many of the strategies are based on these trading approaches. We assume you are familiar with the basics of technical analysis and the major indicators so we do not explain these in great detail.

This is not a book about investing, although many of the strategy examples may be used to improve exit and entry points. A number of the strategies of confusion, deception and desperation are also relevant to investors because the market applies these strategies to their disadvantage. Protection against the application of these strategies is important if investors and traders are to implement effective countermeasures.

The original 36 strategies fall into two groups of three categories each. Each category contains six strategies. The first 18 strategies are applied when you have the advantage. The second 18 strategies are applied when you are at a disadvantage. This is the classic structure and we retain it in this book.

The strategies are discussed separately, but in reality these strategies are combined to provide the most effective outcomes in any situation. The importance is not the detail of the strategies, but the wider thinking to encourage you to understand the strategic context of action in the financial markets.

Strategies of advantage

Strategies 1 through 6 are advantageous strategies. They are applied when you have the luxury of time and resources. Detailed planning is possible so you wait for the best moment to open the trade, or close the trade. This is typically applied as traders wait for a downtrend to end and for confirmation a new uptrend has started. There is no rush. This ability to wait for the best opportunity is the most important advantage enjoyed by a private or independent trader. This planning and time advantage distinguishes these situations from those appropriate for other strategies.

Strategies 7 through 12 are designed to recognize and take advantage of opportunity. This includes detailed examination of opportunities where we wait in ambush ready to capture brief and well-defined trading opportunities. Some of this is short-term snatch-and-grab or ambush-style trading.

It also includes the unexpected opportunities created when prices suddenly explode upwards in a bubble or a parabolic trend. This carries price action well above the trend line, offering significant profits. We examine techniques to recognize and maximize the return from these opportunities.

Strategies 13 through 18 are offensive approaches to the market. We still have time on our side, and the resources, but rather than wait for the opportunity to develop, we aggressively create the circumstances necessary to lock in profits. Understanding order line behavior and the obligations of market makers helps develop successful offensive trading strategies. This is a direct attack on those forces which prevent us from collecting a profit. Taking the offensive delivers profits.

Strategies of disadvantage

Other strategies cannot be used by traders to defeat the market. These are the strategies used against us, and which inhibit our success. The market does not consciously apply these strategies, but the impact of market activity is the same. There is an advantage if we recognize when our success is disabled by the implementation of one of these strategies. Awareness gives us protection so we can develop appropriate defensive responses. Strategy 31, Beauty Scheme, is not an ugly stock disguised as a beautiful trade. It describes the situation where our trade management judgment is influenced by our emotional attraction to the prospect of great returns. It is a strategy applied against us so we defend ourselves by recognizing the strategy and creating trading processes to reduce the ability of emotions to influence our decisions.

Strategies 19 through 24 apply when we do not have the advantage of time or resources. Our profits are under constant attack from market forces so we need to escape quickly. Our victory comes from the way we escape from a trade, taking profits with us. Careful understanding of order line behavior and the reactions of our opponents on the other side of the trade provides a strategy for closing a trade in thin markets. The objective is to confuse the opponent so we can make an escape on our terms without damage. This includes protecting a profit, or cutting a loss quickly in adverse conditions.

Strategies 25 through 30 are deception strategies. They are most commonly used against traders so we must learn to recognize them. The market applies these strategies with success and many traders lose. Inadvertently we also apply these strategies to ourselves and our success is blunted by psychological factors.

On occasion we want to avoid becoming a victim, but on other occasions careful participation in these unfolding market events delivers substantial rewards. Bubble and momentum trades are a type of deception created by market forces. Prices move quickly above reasonable value. If we recognize this deception we can apply better tactics to trade such events without falling victim to the deception. Fast and powerful profits are available for those who are aware. Rapid and substantial losses are delivered to those who are deceived by this market activity.

Strategies 31 through 36 are desperation strategies. Apply these when everything appears to be going against you. In a very important sense, the market is always against the trader. Every trade has three possible outcomes, but only one of these delivers a profit. Once a trade is opened, price may move down, move sideways, or move up. Only an upward move in price delivers profits because even a sideways price movement is a losing trade due to commission and transaction costs. The odds are stacked against the trader 2:1.

Despite this, financial trading is not constantly mired in desperation. The six desperation strategies are applied only when appropriate. They include a deliberate strategy of entering a trade after the real trend break has commenced, and exiting after the trend has ended. This apparent self-injury scheme is an important way to manage the greed that poses a constant danger to our trading success.

The objective in war is total victory. This is not possible in the market. 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, and in this book we substitute this objective for that of total victory. The application of these 36 strategies helps us to survive, prosper and win in the face of ongoing adversity.

Some trading situations lend themselves to a single strategy solution. Many trading situations are successfully resolved using a variety of strategies. Some trading situations require the application of a combination of strategies. For the purposes of this book we have focused on trading events where a single strategy is clearly illustrated.

Unlike books dealing with business studies based on failed or successful companies, it is difficult to find external examples of trading tactics. Trading tactics are personal, and the best books are written by those who trade and know the taste of fear. This cannot be an armchair analysis based on carefully constructed assumptions. Real trading reduces academic theories to tatters as the market creates conditions that challenge theory and practice. I learnt the application of these strategies the hard way — in the market. I have been a victim of some of these strategies. I have applied other strategies successfully to manage exits in thinly traded stocks, or to enhance the success in a trade.

We delved back into our files to find trading examples consistent with these classic Chinese strategies. The examples are drawn from personal trades and from case study portfolio trades included in our weekly trading newsletter, published continuously since 1996. Some examples of these strategies in action are drawn from material published in my books and articles in Your Trading Edge, The Edge in Malaysia, Shares or Technical Analysis of Stocks and Commodities magazine. They are extracted and modified to highlight the issues and relevance of each strategy. They have been recast to bring out the strategic relationships. These are practical trading methods culled from experience.

Many of the strategies are enhanced, or in some cases only made possible, by using derivatives. These derivatives can be a trader’s best friend — or worst enemy. Derivatives such as warrants and CFDs are not ordinary shares. Traders who find success elusive when trading ordinary shares are most unlikely to suddenly become successful trading derivatives.

Matching these 36 strategies with specific trading situations in the financial market is not always a straightforward task. Some latitude has been used because the nature of our enemy changes. Unlike the battlefields in the countryside, or the politics of the Imperial court of ancient China where these strategies developed, our battlefield is a more fluid arrangement with multiple enemies making both external and internal adversaries.

The implementations of the strategies discussed here in the case studies are not exhaustive. Treat them as examples of the types of tactics which are applied to implement these strategies. Many can be extended further to associated markets, such as CFDs, options, forex and commodities. The principles hold true for all markets and instruments because we usually participate in the market from a position of relative disadvantage. It takes skill to win and win consistently.

Some techniques are applied successfully to several different strategies. The techniques may be essentially the same, but the way they are applied to achieve particular strategy outcomes is different. Trading rights issues is a way to implement Strategy 1, Deceiving Heaven to Cross the Sea, and also an example of Strategy 7, Creating Something out of Nothing. In strategy 1 we have time for careful planning and we develop the opportunity. In strategy 7, we recognize the opportunity created by external circumstances.

Making an entry or an exit when market volumes are thin is a tactic applied in Strategy 6, Making a Feint to the East While Hitting Out in the West, and is also applied in Strategy 21, The Golden Cicada Sheds its Skin. Strategy 6 is applied from a position of advantage, carefully timing each move. In strategy 21 we use the same techniques from a position of disadvantage so the application is slightly different and designed to conceal our weakness. We have selected the case studies to highlight these differences in application.

This is not an exhaustive collection of trading technique examples. In selecting some case study examples we have highlighted the more unusual implementations. In discussing takeover trading tactics we look at short-term arbitrage opportunities rather than the traditional buy-and-wait-for-a-better-offer approach. Experienced traders will quickly recognize other trading methods and situations that fall easily within the framework of the 36 strategies. Triggering this recognition is one of the objectives of this book. It is designed to help traders think more structurally and strategically about the way they interact with the market.

In the past I have read several books illustrating the application of these strategies to business. These were written in English, so they were easy to read and comprehend. This ease also meant the true significance of many of the strategies was elusive. Ease of reading sometimes leads to shallowness of understanding. Working in China and working with Chinese friends removed these strategies from the realm of comfortable theory. I saw them applied every day, cementing relationships, confirming friendships and, for me, opening new possibilities of understanding.

The foundation of this book is not my work. It rests on centuries of Chinese tradition, scholarly interpretation and understanding. My understanding draws on the work of scholars such as Wee Chow Hou and Lan Luh Luh who have successfully translated these strategies into the modern business marketplace. It rests on interpretive work by authors as diverse as Stephan Verstappen, Harro Von Senger, Wang Xuanming and Chin-Ning Chu. My understanding also draws from textbooks used in Chinese middle schools. This philosophy and these principles are alive and well in Singaporean and Chinese education systems. Slowly reading these textbooks in Chinese, assisted by my friend, Weili Chen, compels a more studied examination of the strategies simply because it requires additional effort to understand and comprehend the Chinese characters.

The insights into the interpretation of the 36 strategies have been enhanced by discussion and criticism provided by Chen Jing, CEO of the GuppyTraders Beijing office. She continues to coach me with her skilled practical application of these cultural and philosophical foundations. Leehoon Chong has again done an exemplary job of proofing the original manuscripts, bringing skill, enthusiasm, and dedication to the task. With unfailing certainty my mother Patricia added the final touches to the manuscript, deleting unclear expression and suggesting alternatives. Several generations of students gained much from her work as an English teacher and I continue to reap the benefit of her marking pen. Finding time in a busy office and a hectic traveling and trading schedule to write and re-write is made possible by the efficient organization of the office by Amy Chui Choo Calder and Despina Kaltourimidis. My wife Marion gracefully accepted extra sleep-in time during her well-deserved holiday while I worked on the first draft early every morning.

In a world that seems information-rich and time-poor it is all too easy to ignore the context of our activity. The financial market is a dangerous and rewarding place. Consistent success demands mastery of technique, of trading discipline, and of ourselves because we operate in an area where greed and emotion are unfettered. It may appear the struggle for survival is based on lightning-fast reactions to each emerging crisis, but this is incorrect. The 36 Strategies of the Chinese for Financial Traders gives traders a means to lift their heads above the skirmish activity inherent in every trade and focus on the wider context of their relationship with financial markets. The 36 strategies of the Chinese for financial traders are strategies for success in financial markets and I encourage you to use these observations to improve your trading activity.

Trade exceptionally well.

Daryl Guppy

Darwin, Australia, 2006

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PART I

ADVANTAGEOUS STRATEGIES

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STRATEGY 1

DECEIVING HEAVEN TO CROSS THE SEA

Explanation

The objective is to create a false impression so the target, or victim, is caught unawares. The plan is carried out under the cover of normal, everyday conditions. The victim is distracted from his concerns.

Origins

There are conflicting origins of this strategy. One concerns a clever trick to deceive the Tang Dynasty Emperor, Tang Tai Zong. The Emperor was known as the Son of Heaven, and in this strategy Heaven is used to represent the Emperor. He did not want to cross the sea so he was deceived into believing he was at a feast when in reality he was under a tent on a boat crossing the sea he feared. He was distracted by food, wine and beautiful dancers.

Another original story concerns the founder of the Sui Dynasty who decided to invade the Chen Kingdom to the south of the Yangtze River. In 589 AD he instructed General He Nuobi to invade the Chen Kingdom. The general camped on the north bank of the river and began to practice military maneuvers. The King of Chen was alarmed and massed his troops on the southern bank of the river. The maneuvers continued, but no attack developed. The King of Chen dismissed the activity as a practice drill and stood his troops down. He Nuobi increased his military activity and instructed his officials to purchase many boats. The Chen forces became accustomed to the on-again, off-again military maneuvers on the northern river bank, and relaxed their vigilance. What was initially frightening had become routine and his forces no longer patrolled day and night. Using his new boats, He Nuobi’s troops launched a night attack and quickly captured the Chen capital, which is present-day Nanjing.

Trader’s translation — using arbitrage returns in rights issues

This strategy affects traders in two different ways. The first is where we apply this strategy to ourselves to enhance our success. The second is where we apply this strategy to the market.

The first application brings success in the market by ‘deceiving’ our inclination to apply previously successful business skills to the task of trading stocks in the financial market. If we are able to deceive Heaven — ourselves — we can cross the sea to the far shores of market opportunity. Although we find ourselves adrift on an uncomfortable sea of uncertainty we must put aside our fears and focus on those elements of everyday events that hold the key to market success while discarding those that hold us back. Uncertainty is defeated by probability, not prediction.

The second application of the strategy is when traders apply this strategy to market trading. We look for concealed advantages lurking under the cover of everyday events. Our objective is to cross the sea — to snatch a profit from the everyday activity of the market that conceals the opportunity from others who are less observant. This is a trading edge and it comes from deceiving Heaven — the rights issuer who wants to raise capital by taking money from us.

In trading terms we find this situation with rights issues. Rights are an expansion of the number of shares available in the company. Rights are issued at a discount to the current share price. For a short time they can be traded separately. Traders add to existing positions or open a new position using a discount entry with a known market price for the converted right. Using these trading methods we deceive Heaven — the way the company intends these rights to be traded — to cross the sea — achieving an additional profit objective.

Traders who own the stock are like consumers ‘hooked’ on a software suite. When the next upgrade comes, they are automatic buyers. Microsoft and other software developers realize that the potential for future sales provides a steady profitable income. When we upgrade to the next generation of Windows we rarely examine the true costs. In the market, when we receive a rights issue we usually do not examine the additional opportunities or the hidden options available in the situation.

The rights issue is really an arbitrage opportunity. These opportunities exist when we can buy a stock in one place and sell it immediately in another place for a better price. A rights issue is the starting point for the strategy. Assume company JiHui issues a 2:1 rights issue. For every two shares you own you are given the right to purchase one share. The company is Heaven in this application of the strategy. Their intention is to raise more capital. Our intention is to cross the sea and make a profit, so we must deceive Heaven. The market gives us the necessary everyday conditions to conceal and implement this strategy.

Rights are generally offered at a discount to the current market price and this provides an arbitrage profit opportunity. 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 an arbitrage short sale and may deliver a 10% to 15% profit.

The strategy is further finetuned to exploit market conditions, boosting returns to 40% or more. This is an almost risk-free return because the strategy is not implemented until we are certain we have captured a profit. We do not sell until the profit is clearly in place. We lock in the profit by taking up the obligation of the company to deliver shares to us at this lower price. We deceive Heaven to cross the sea.

Application 1 — deceiving ourselves

Deceiving Heaven to cross the sea is a beneficial strategy when used to achieve a profitable trading objective. It is a disastrous strategy when it prevents us from achieving our objective. Many people who have successful careers use their entrenched habits and customs when they enter the market. In time, these habits distract them from the dangers lurking in the market. Strategies that bring success in business are likely to bring disaster in the market. The successful businessman often has held on when things were grim only to emerge victorious and profitable because he has controlled the external factors in his segment of the market and outlasted his competitors.

For instance, he may analyze the consumer market to predict a developing shortage of selected services. This analysis gives him the power to control events by opening expanding services to meet the identified demand. To him, it seems that superior analysis means control and this equates with success. Not so in the market, but the idea is difficult to discard because it has given him the wealth to trade in the first place.

Past business success nurtures the unspoken conviction that if he can understand the key market factors or information then he can call the market and make a profit. A small series of successful market predictions helps to reinforce this erroneous idea. Instinctively, we reward ourselves, and others, for being right when they correctly call the market direction.

Eventually, the businessman begins to believe that his understanding of the market means that when he takes a position it must move in his favor. When a position turns against him, he is stunned, and holds on, waiting for the market to reverse and match his previous market call. He rationalizes what he is doing: ‘I have been right before so this will come good,’ or, ‘Perseverance pays, so I will stay where I am.’

The need for control — the need to be right — produces some creative excuses for trading failure: ‘I am surprised the market does not realize the potential of this stock. I will buy more now they have gone lower.’ No matter how foolish these excuses seem in retrospect, the want-to-be trader has to convince himself they are valid because to do otherwise is a larger threat to his self-esteem. Essentially, he struggles to control the market because control of the business environment has brought him success in the past.

The trader makes his profit by controlling the only element he can realistically control — himself. He should apply an analytical framework to improve his understanding of the market so he can make consistent decisions about how he is going to trade the market as it is, rather than the way he would like it to be.

There are many businessmen who successfully make the transition from business to trading. The most successful are those who understand that the rules which allowed them to accumulate business wealth are not the rules that favor trading profits.

In this way, the successful businessman is able to deceive Heaven to cross the sea and reach the further shore to find consistent trading success.

Application 2 — using rights as hidden options

Every now and then the market provides us with an almost risk-free way of collecting a good return. This is a direct result of the mechanics of the market and is not directly related to trends, pattern recognition, or technical analysis. These are arbitrage situations that occur because the current stock price, or stock you hold, has a hidden option.

The objective of the rights issuer is to raise more capital. Our objective is to take a profit from this activity. To achieve this, we must deceive Heaven — the rights issuer — to cross the sea and capture our profit.

We start with the general outline of the strategy, and then put some figures on it. The arbitrage opportunity arises when a company like Highlands Pacific (HIG) issues new shares as a rights issue. These offers allocate shares at a known set price; in this case, at $0.25. This gives existing shareholders the opportunity to add to their shareholdings through a non-renounceable rights or share issue. This means the ‘rights’ to the shares cannot be traded on the open market. It also means, as with any option, you have the opportunity, but not an obligation, to take up this offer. If you reject the offer you are not allocated extra shares so you do not have to pay any money.

The first step when the offer arrives is to see if the proposed offer price — $0.25 — is less than the current market price. In a bear or nervous market, it is not unusual to find the market has fallen to the value of the rights issue, as shown in figure 1.1. If we accept the offer to buy at $0.25 then the danger is once the closing date for the offer has passed the price will fall, as shown by line A. This result means we have more shares than we started with, and they are worth less than what we paid. This is not a good outcome.

Figure 1.1 Rights issue

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Although the price may initially fall to the same level as the share issue price there are circumstances where the stock stages a rally. This is shown in area B. If we were able to buy the shares at the start of area B and sell them at the peak of the rally then we could make a 10% to 20% profit. The problem with this strategy is twofold.

First, we cannot sell the shares we are purchasing as they will not be delivered to us until after the closing date. The rise in price is taking place now and we do not get the shares for another 15 days or so.

Second, once the share issue closes, particularly if it is under-subscribed, the price is likely to fall substantially, as shown by line A. Even if the rally lasts right up until the closing date, there is a danger we will not be able to sell at a good price after the issue has closed. Again, this is complicated by the slow delivery of the new shares we have purchased. It is very easy to be embarrassingly trapped when we sell the new shares only to find they have not yet been credited to our account.

However, this situation reveals the core of an effective arbitrage strategy using the ‘hidden options’ that allow the trader to realize the value of the hidden option at the peak of the rally.

This strategy applies only to traders who already own the stock. Although HIG fell from $0.34 to $0.25 when the share issue was announced there are many reasons why the trader or investor might choose to hold on to the stock. The essential pre-condition for this strategy is that the trader must hold HIG stock already and so be entitled to the share issue.

The strategy is date-based and starts with the date at which the share entitlement is announced. The key events are shown in figure 1.2. Once announced, the number of shares we are entitled to does not change. The second date is determined by the last date for the delivery of payment to the share registry. We may choose to sell the shares at any time, but we must ensure the shares are paid for by the cut-off date.

Figure 1.2 Arbitrage opportunity

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The core of the strategy rests on dipping into our existing parcel of shares — parcel A — to sell the parcel that we know we are going to buy in the future — box B and box B1. Once the full strategy is completed we finish with the same number of shares in parcel A that we had originally.

The risk of this strategy is lowered in two ways. First, we are selling at a high price today knowing we are going to buy the shares back at a set lower price after a known date. This is almost the equivalent to shorting the stock, but without the danger of margin calls.

Second, the strategy is not initiated until it is a proven success. We do not sell in anticipation. We sell only when the strategy has proven profitability.

The diagram in figure 1.3 shows the strategy in action. Assume we already hold 100 000 shares. Also assume we are entitled to buy 20 000 shares at a known purchase price — $0.25 — by the cut-off date. As the rally peaks we dip into our existing portfolio of shares and sell 20 000 shares at $0.35. We know these shares will be replaced because we intend to exercise our right to buy a replacement parcel of 20 000 shares at $0.25 by the cut-off date. We sell shares for a total of $7000. We buy back the shares — our rights issue — at $0.25 for a total cost of $5000. This trade delivers a 40% profit.

Figure 1.3 Strategy in action

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As soon as we sell 20 000 shares, shown as box B1, we immediately complete the rights payment and send it to the registry office to take up the offer to buy the 20 000 shares at $0.25. The new purchase is shown as box C. We draw on our own funds, or use the proceeds from the sale. In either case, this trade is self-funding because we get the money from the sale before we have to send the money to buy our share entitlement. It does not matter how long it takes to deliver the shares to us. The counterparty in the trade has received his shares because we sold them from our existing portfolio. Days, or sometimes a week or more, after the cut-off date, the new 20 000 shares — box C1 — we purchased for $0.25 are credited back to our portfolio. The net result is we still own 100 000 shares but have collected a 40% return from the moment of market inefficiency. We deceived Heaven to cross the sea.

This is an almost risk-free return because the strategy is not implemented until we are certain we have captured a profit. We do not sell until the profit is clearly in place — when the stock trades at $0.35. We lock in the profit, not by the sale, but by purchasing the shares at a known lower price and taking up the obligation of the company to deliver them to us at this lower price. The company believes we are buying the rights issue to help them, but in reality we purchase the rights to snatch a profit from the normal activity of the market.

The core of trading success lies in the return on capital. Collect a 16% return here and a 10% return there on a regular basis and it soon builds into a substantial cumulative realized percentage return on total capital. We reach big account numbers small step by small step at a time.

This strategy is scaleable. Some similar opportunities offer similar percentage returns which translate into much larger dollar returns because the stockholder is entitled to buy a much larger number of shares at a known price.

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STRATEGY 2

BESIEGING WEI TO SAVE ZHAO

Explanation

It is prudent to avoid attacking the enemy head-on. It is better to wait for the enemy to reach his weakest point, and then attack. If the enemy can be dispersed and exhausted, then successful attacks can be made against each separate enemy.

Origins

During the Warring States Period, six states became powerful, but not strong enough to dominate the country. This created a sea of shifting alliances. In 353 BC the state of Wei attacked the state of Zhao. The ruler of Zhao appealed for assistance and the King of Qi ordered a rescue attempt to lift the siege of the Zhao capital, Han Dan.

Rather than attack the Wei army directly while they were in the foreign state of Zhao, the King of Qi decided to attack the main city in the state of Wei. With so many soldiers away, the defense of the city of Da Liang was weak. When the Wei army heard of the attack on their home city they abandoned the siege in Zhao and began a forced march to counter the attack on their homeland. Exhausted by battle and the forced march, they were easily ambushed and defeated by the Qi army.

Trader’s translation — trade market areas ignored by others

When we trade the market we always face an adversary who is much stronger than ourselves. The market is powerful and we can do nothing to affect its chosen course. Traders are constantly warned of the dangers of trading against the trend. In this sense, we are faced with a group of powerful enemies who are constantly attempting to take our money from us and reduce our trading capital. Even in a bull market, many stocks continue to move down, or fail to match the performance of the market.

The essence of this strategy is to attack in areas which are least expected. It has a familiar ring of classic investment strategies which focus on stocks of fundamentally good value which have been ignored by the market. The strategy