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You Can't Become Rich In Your Pocket Until You Become Rich In Your Mind | ||||
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Livermore had a reputation as a high-flying speculator, not unlike a high-stakes gamblerTiming Is Everything Like the old real estate adage that everything is location, location, location, in trading the stock market it is timing, timing, timing. In order to assure himself that his timing was correct Jesse Livermore went through a complex checklist before he pulled the trigger on a trade. It was also his observation that on many occasions the timing on selling a stock was just as crucial as buying a stock; in fact, sometimes the selling was the more difficult decision. Any stock trader will tell you that stock buying is the easier of the two tradesgetting in is the fun part. When traders buy stocks they are full of hope and perhaps a touch of greed, so when they pull the trigger and buy a stock there is often a feeling of elation, euphoria, similar to the feeling a person gets when he makes a major purchase such as a car, or a house, or a boat. These feelings stem from the emotions of hope and greed. It is later, if the trade shows losses that these emotions often turn into fear. The trader has to fight a constant emotional battle. This is where the second phase of Livermores Trading System, the Money Management phase, becomes essentialchoosing the moment to sell. Even if the stock goes in the right direction and the trader prospers by gaining several points, he still has to decide when to sell his position: Should I take the profit now, or should I wait? The Livermore philosophy on this point is simple, like the rest of his trading strategies. You need valid reasons to buy, and you need valid reasons to sell. Some of Livermores greatest long-term triumphs in the market occurred when he bought a stock and waited for a valid signal to sell. This book explains in detail when the buy signals occur and when the sell signals appear. It will be up to the astute trader to follow these signals correctly. Your timing should never be dictated by high prices. High prices were never a timing signal to sell a stock. Just because a stock is now selling at a high price does not mean it wont go higher. Livermore was just as comfortable on the short side, if that was the direction of the trend. Just because a stock has fallen in price does not mean that it wont go lower. Livermore said: I never buy a stock on declines, and I never short a stock on rallies. Buying stocks as they made new highs and selling short as they made new lows was a contrarian point of view in Livermores day. He let the market tell him what to do. He got his clues and his cues from what the market told him. He did not anticipate; he followed the message he received from the tape. Some stocks keep making new high or lows for a very long time, and therefore can be held for a very long time. Livermore had a reputation as a high-flying speculator, not unlike a high-stakes gambler. Nothing could have been further from the truth. Livermore was more conservative in his trading than anyone ever knew. The Livermore Trading System was a disciplined procedure for him. Simply stated, it was an attempt to place as many factors in the traders favor as possible. Or, put a different way, dont make a trade until all the odds are in your favor. The trick for Livermore was to have the discipline to often refrain from trading until the perfect, or as close to perfect as possible, trade came along. And they did. Like streetcars, another one always came alongbetter to miss one than to get on the wrong car and take a trip to financial hell. With this in mind, the first thing Livermore did in his timing system was to check the overall direction of the market. It is important to reiterate that he did not care which direction the market was moving. There was always a trade possible for him, either up or down, short or long. He always wanted the wind at his back. He wanted to trade with the trend, not against it. This may sound simple but just consider how many sophisticated mutual funds and investors were buying stock during the last few years when they should have been out of the market altogether, or selling short! Figures 2.1-2.3 illustrate the dramatic fall the stock markets experienced over the last three years. They had been in decline long before the 9/11 tragedy and bottomed out soon after that date. The only way traders could make money in such a market was to trade the short side. This is usually prohibited for most mutual funds, which eliminated these type of funds from the possibility of making a profit under these circumstances. Few people understand the short side of the market. In Livermores day, as in the climate of todays trading, very few people would speculate on a stock going down. In fact, very few people understand that you can actually place an order to short a stock and make money as the stock price declines. Less than 4 percent of investors or traders actually ever short stocks. Livermore shorted stocks, and this was one of several specific reasons why he was such a successful trader. He had concluded that the stock market goes up approximately a third of the time, sideways a third of the time, and down a third of the time. Therefore, if a trader only trades in anticipation of a stock rising in price he is wrong on the trade two thirds of the time! The speculator Louis Smitten defines the steps of a short sale as follows: the sale of stock you dont own, in anticipation of a drop in price. 1. Stock is borrowed from your broker for delivery to your account. 2. Later, you purchase stock in the open market and return it to your broker to pay back the stock you borrowed. This completes the transaction. In other words, the stock is sold first, then bought back at a later date, and at, it is hoped, a lower price. This is the reverse of a normal buy-first, selllater transaction. So, the first step in the Livermore procedure before making a trade is to determine the direction of the overall marketLivermore referred to this as determining the Line of Least Resistance. He did not generally use the terms bull or bear for a very specific reason: He felt these terms led the trader to have a mind set that would cause him to anticipate the direction of a trade or the direction of the marketa deadly and dangerous thing to dobecause the market is a dynamic entity driven by peoples emotionsnot reason. Dont try and anticipate what the market will do nextsimply go with the evidence of what the market is telling youpresenting to you. Jesse Livermore This is a complex, confusing area for traders in understanding the Livermore theory. There are times when his approach may appear contradictory and confusing. You may ask yourself: Isnt Livermores whole theory a way of anticipating the direction of the market before it happens? In the Livermore Trading System, the answers are always apparent in the actual performance of the stock. It is the traders job to investigate the facts and solve the mystery, to be like Sherlock Holmesonly deal in the facts that are presented by the stockDo not anticipate what will happen nextAlways wait for the market to confirm your trade. The successful speculator must formulate his plan in advance of a stocks movement. Because the market is driven not by logic but by emotion, it is most often unpredictable and goes against logic. Livermore believed that to even out the odds and increase the safety of a trade the trader had to wait for the market to confirm his judgment. This required patience and discipline, two rare traits in most people. But if you follow this advice, you are in effect getting insurance on your position because you have waited until the market has shown you what it is going to do. The rule is not to place your trade until the market itself confirms your opinion or shows you a different path to follow. News items can often be deceiving. They can have less of an effect on the market than one might think or, by contrast, they can have a greater effect. The point is that there is no telling what effect news will have. As can be seen by the previous charts (Figures 2.1, 2.2, and 2.3), after the tragedy of 9/11 the market went down, but not as deeply or for as long as had been predicted. This was because the market had already been declining for more than a year. It is too difficult to know what is going on in the inner workings of the market at the time of a news release. To illustrate: Perhaps the market has been in a long-term period with plenty of solid momentum behind it. In that case, a bullish or bearish piece of news may have no effect. The market also may be in an overbought or oversold condition and absorb the news item without a tremor, effectively ignoring the news. When dealing with the news and its impact on the stock market, do not anticipate by using your own judgement and in effect guess what will happen. You must study the action of the market itself. As Livermore said: Markets are never wrongopinions often are. He also remarked: Timing in the stock market is the key to success. A trader may deduce that a stock is going to go up or down in a big way and eventually he may be correct. In fact, if you have any experience in the market this will ring true. I knew that stock was going to go up ten pointsI was just too darn early on the trade. I lost my money but I was ultimately right on the stock. I just moved too soon, the market went against me and I sold out my position for a loss. I even made a second attempt to buy it and it dropped three points, I got nervous, so I sold it. Often a trader will move too soon and then doubt his opinion on the stock and sell it out. Or perhaps he makes other commitments and has no money left to buy the stock when it does make a move. Having been too hasty and having made two erroneous commitments, he loses courage. This is a common lament of stock traders. What a trader is battling here is basically his greed. He wants every point out of the move and will kick himself if he is a point or two on the late side of the trade. Dont be anxious to make the trade. Wait for the confirmation of the market before you place your order. Think of it as a small insurance planlose a point or two and help eliminate the bad trades on the times when you are wrong and everyone is wrong on at least some of their trades. Say, for instance, a stock is selling around $25 and has been consolidating within a range of $22 to $28 for a considerable period. Assuming that you believe that the stock should eventually sell at $50, have patience and wait until the stock becomes active, until it makes a new high, at around $28 to $29. Watch for an increase in volume activity, say 50% or more over normal volume. You will then know that you are correct. The stock must have gone into a very strong position, or it would not have broken out. Having done so, it is altogether likely that it is starting a very definite advancethe move is on. That is the time for you to back your opinion. Dont let the fact that you did not buy at $25 cause you any aggravation. The chances are if you had, you would have become tired of waiting and would have been out of it when the move started, because having once gotten out at a lower price, you would have become upset and perhaps fearful, and would not have gone back in when you should have. A key factor in the Livermore Trading Systems timing approach is to be correct in the trade right from the beginning. You should have waited patiently until all the factors were in place before pulling the trading trigger...therefore the stock should move in the direction of your trade almost simultaneously with entering the trade . . . that is, if you have acted correctly and been patient. By contrast, if you have made a decision to enter a trade and the stock does not move quickly, and perhaps just lies there, languishing going sideways, or if it moves against you in the opposite direction of your trade, you should consider immediately closing out that trade. Experience proved to Livermore that the real money made in speculating was in commitments in a stock or commodity and showing a profit right from the start. Livermore believed that if he was right in his timing and pulled the trading trigger at the appropriate moment, then the momentum would be like a tidal wave right behind the trade, and it had to go up. Therefore, if the stock did not go up right away he would have to assume his judgement was wrong. Yet there were times when Livermore admitted he did not have the patience to wait for the right moment, because he wanted to constantly be in the market. You may well ask: With all his experience, why did he allow himself to break this rule? Livermores answer: He was human and subject to human weakness. Like all speculators, he permitted impatience to outmaneuver good judgment. There are aspects of trading that are very close to gambling, such as playing card games like poker and high-stakes bridge, which Livermore did every Monday night in his mansion on Long Island. Everyone who enjoys these games has an inclination to play every hand and win every pot. It is a key finger on the hand of greed, and if not curtailed by the self-discipline to adhere to the traders own rules, it will almost surely become his greatest flaw. If not understood, it will surely bring about his downfall. Livermore exhorts the trader to have patience and wait until all factors are in his favor. Livermore spent a great deal of time trying to determine when to sell a stock. The timing on the sale of a stock is just as important as the purchase. Your buy can be perfect, but unless you sell at the right time, the entire trade may not show a profit. It is a human trait to be hopeful, especially when you buy a stock; and to be equally fearful when you sell. Livermore believed that when you inject hope and fear into the business of speculation, you face a very formidable hazard, because you are apt to get the two confused and in reverse positions. Here is an illustration of the timing sequence in a typical trade. You buy a stock at $30.00. The next day it has a quick run-up to $32.00 or $32.50. You immediately become fearful that if you dont take the profit, you may see it fade awayso you sell and exit the trade with a small profit, at the very time when you should entertain all the hope in the world. Why should you worry about losing two points profit that you did not have the previous day? If you can make two points profit in one day, you might make two or three the next day, and perhaps five more the next week. As long as a stock is acting right, and the market is right, be in no hurry to take a profit. You know you are right, because if you were not, you would have no profit at all. At this point, you should let the stock ride, and ride along with it. It may make a very large profit. As long as the market action does not give you any cause to worry, have the courage of your convictions . . . stay with it. By contrast, suppose you buy a stock at $30.00, and the next day it goes to $28.00, showing a two-point loss. You would not be fearful that the next day would possibly see a three-point loss or more. No, most traders would regard it merely as a temporary reaction, feeling certain that the next day it would recover its loss. But that is the very time when you should be worried. That two-point loss could be followed by two points the next day, or possibly five or ten within the next week or two. That is when you should be fearful that, because you did not get out, you might be forced to take a much greater loss later on. That is the time you should protect yourself by selling your stock before the loss assumes larger proportions. Livermore learned that profits always take care of themselves but losses never do. His doctrine for the trader was to insure himself against considerable losses by taking the first small loss. In so doing, the trader keeps his account in cash so that at some future time, when a good trade presents itself, he will be in a position to go into another deal, taking on basically the same amount of stock as he had when he was wrong. This strategy allows the trader to be his own insurance broker, because the only way he can continue trading stocks is to guard his capital account and never permit himself to lose enough to jeopardize his overall operations and be unable to trade at some future date, when his market judgment is correct. Livermore was convinced that nothing new ever occurs in the business of securities or commodities trading or investing. There are times to speculate, and just as surely there are times not to speculate and stay out of the market. He believed in a very true adage: You can beat a horse race, but you cant beat the races. This is true with the stock market. There are times when money can be made investing and speculating in stocks, but money cannot consistently be made by constant trading every day or every week of the year. Only the foolish will try. He felt that this strategy just was not in the cards and could not be done. The trader may ask himself a major timing question: Why cant I just pick the correct time to buy a stock and then just forget about selling that stock because I am in for the long haul? If the last three years has taught us anything, it should be that there are no stocks that can just simply be bought and put away, hidden in our mattresses for the years to come. Livermore believed that there are no good stocks! There are only stocks that make money! This book offers some of Jesse Livermores dos and donts for traders. One of the primary donts is: One should never permit speculative ventures to run into investments. Dont become an Involuntary Investor. Investors often take tremendous losses for no other reason than that their stocks are bought and paid for. How often have we all heard an investor say: I dont have to worry about fluctuations or margin calls. I never speculate in the market. When I buy stocks, I buy them for an investment, and if they go down, eventually they will come back. But unhappily for such investors, many stocks bought at a time when they were deemed good investments have later met with drastically changed conditions. These such so-called investment stocks frequently become purely speculative. Some go out of existence altogether. The original investment evaporates into thin air along with the investors capital. This is due to the failure to realize that so-called investments may be called upon in the future to face a new set of conditions that would jeopardize the earning capacity of the stock, which was originally bought for a permanent investment. By the time the investor learns of this changed situation, the value of his investment has most likely already greatly depreciated. The stock market moves in future time, not present time. Therefore, the so-called investor must guard his capital account, just as the successful trader does in his speculative ventures. Then, those who like to call themselves investors will not be forced to become unwilling investorsnor will trust fund accounts and mutual funds accounts depreciate so much in their value. In Livermores time it was considered safer to invest money in railroad stocks such as the New York, New Haven & Hartford Railroad than to have it in a bank. On April 28, 1902, New Haven was selling at $255 a share. In December of 1906, Chicago, Milwaukee & St. Paul sold at $199.62. In January of that same year, Chicago Northwestern sold at $240 a share. Look at those safe investments approximately 40 years later. On January 2, 1940, they were quoted at the following prices: New York, New Haven & Hartford Railroad $.50 per share; Chicago Northwestern at 5/16, which is about $0.31 per share. On January 2, 1940, there was no quotation for Chicago, Milwaukee & St. Paul, but on January 5, 1940, it was quoted at $.25 per share. In Livermores time, hundreds of stocks considered gilt-edged investments eventually were worth little or nothing. Great investments tumble, and with them the fortunes of so-called conservative investors in the continuous distribution of wealth. There is no question that stock market traders have lost money. But Livermore believed that the money lost in the long run was small compared to the gigantic sums lost by so-called investors who have let their investments ride. The same is true in the current 1999-2004 stock market, as illustrated in the market charts at the end of this chapter. From Livermores viewpoint, the investors are the big gamblers. They make a bet, stay with it, and if it goes wrong, they lose it all. The trader might buy at the same time. But if he is an intelligent trader, he will recognizeif he keeps recordsthe danger signals warning him that all is not well. He will, by acting promptly, hold his losses to a minimum, and await more favorable market conditions, or trade on the short side of the market. When a stock starts sliding downward, no one can tell how far it will go. Nor can anyone guess the ultimate top on a stock in a broad upward movement. Livermore recommended a few thoughts that should be kept uppermost in the traders mind. Never sell a stock because it seems high-priced. You may watch the stock go from 10 to 50 and decide that it is selling at too high a level. This is the time to determine whether anything will prevent it from starting at 50 and going to 150 under favorable earning conditions and good corporate management. Many have lost their capital funds by selling a stock short after a seemingly too high, long upward movement. Study the stock on the basis of current conditions, looking for a clear reason to sell. By contrast, never buy a stock simply because it has had a big decline in price. The decline is probably based on a very good reason. For example, the stock may still be selling at an extremely high price relative to its valueeven if the current level seems low. Livermores trading method may come as a surprise to most traders. When he saw, by studying his records, that an upward trend was in progress, he became a buyer as soon as the stock made a new high on its movement, after having had a normal reaction. The same applies whenever he took the short side. Why? Because he was following the current trend direction, and his records signaled him to go ahead. It was a safe trade. The Livermore trading system insists that it is foolhardy to make a second trade, if your first trade shows you a loss. As an ironclad Livermore rule, never average losses. Let that thought be written indelibly and forever upon your mind. Some 2004 examples of blue chip stocks reinforce Livermores own words. (See Figures 2.4-2.10.) There are no good stocksonly stocks that make you money. Some people considered these stocks as unassailable . . . safe as money in the bank. These blue chip stocks include: General Electric Coke Lucent General Motors Microsoft Sun Microsystems Intel Perhaps these blue chip gilt edged stocks will come back in the future, but there is no doubt they will need many years to recover. The emotional hell of their owners is inestimable. |
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