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You Can't Become Rich In Your Pocket Until You Become Rich In Your Mind | ||||
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Livermore never used the terms bull or bear because they forced a mind-set that he believed made his thinking less flexibleWhy Industry Groups Move Together If you were to ask todays market pundits why industry groups move together, you would be subjected to a lengthy, probably convoluted, answer. Like many other aspects of his market views, the group movement premise was quite simple to Livermore. He explained it in one sentence: If the basic reasons are sound why U.S. Steels business should come into favor in the stock market, then the rest of the steel group should also follow for the same basic reasons. The converse to this premise, of course, also works for playing the short side of the market: When a group goes out of favor for a common basic set of reasons, just as it went into favor, it will include all the stocks in that industry group. The industry group charts in Figures 3.1-3.3 illustrate the general direction of three current groups: The Internet Group, the Broker/Dealers, and the Housing Group. Note: It was also an important clue for Livermore that, if a particular stock in the favored group did not move up and prosper with the others, this could mean that perhaps this particular stock was weak or sick, and therefore might be a good short sale or at the very least, the trader should be cautious in buying it. It can act as a red warning flag that the stock may be in trouble. The only exception to group movement is when a single stock may comprise over 50 percent or more of the total sales of the group, as is currently the case with Intel and Microsoft, who dominate their Industry Groups. In these examples, you do not need to examine the two leading stocks in the industry group; one will do the job, because sooner or later the rest of the group must follow the single dominant leader. Also note this may not always be the expected, conventional stock in the group. Occasionally, a smaller, well-managed stock will assume leadership, perhaps with a new product or strategy, and may knock out the old leader. Keep alert! Choose the most powerful stock in the group, not the best bargain or a beaten down stock poised to recover. DISCOVERY 3: TOP DOWN TRADING The concept of Top Down Trading is very straight forward, involving four steps. Before making any trade on any particular stock, you must first check off the following items: First, check the line of least resistance to establish the overall current market direction. Remember, Livermore never used the terms bull or bear because they forced a mind-set that he believed made his thinking less flexible. He used the term line of least resistance. He checked to see if the current line of least resistance was positive, negative or neutralsideways. Be sure to check the exact market the stock trades onfor instance, does the stock you are interested in trade on the Dow, the Nasdaq, or the Amex? Establish this before executing the trade. It is essential to make sure the lines of least resistance are in the direction of your trade before entering the trade. See Figure 3.4 where the Nasdaq formed a pivot point and changed basic direction. Here the Nasdaq formed a pivot point and changed basic direction. Step 2: Track the Industry Group Check the specific Industry Group. If you are considering a trade in AT&T, check out the Telecommunications Long Distance Group. If Haliburton is your trade of choice, check out the Oil Well Drilling Group. If you are looking at a trade in Harrahs Entertainment, check out the Leisure Gambling Group. Make sure the group is moving in the correct direction, the line of least resistance, in order to increase your chance of a profit on the trade you have selected. In the example below, the trade is in the Internet Industry Group. The Internet Industry Group began its recovery in February/March of 2003, the same time as the Nasdaq. (See Figure 3.5.) In March/April, it gave a clear sign that the line of least resistance was upward. The signals confirmed each other that the trend was now to the upside. Step 3: Tandem Trading Tandem Trading involves comparing two stocks of the same group. Compare the stock youre interested in trading with the sister stock. For example, if you plan to trade in General Motors, check a sister stock such as Ford or Chrysler/Mercedes. If you are going to trade Best Buy, than check Circuit Citya sister stock. Tandem Trading Example: The stocks chosen for this example are Morgan Stanley and Merrill Lynchthe two leaders in the Broker/ Dealer Group. Both stocks bottomed out in February/March of 2003 and gave a signal, by pivotal point, that the line of least resistance was positive. Because the broker/dealers are also often an important bellwether group for what the market may do in the future, this chart action (see Figure 3.6) was a precursor of what was to come in the overall markets. Step 4: Examine All Three Factors at the Same Time Look at the market, the Industry Group, and the Tandem Industry Group stocks in one glance. (The example of this is seen in the new Livermore Software from Stock Market Solutions, on the opposite page.) In the example, it can be clearly seen how the system works, when all factors are in unison. All the signals in Figure 3.7 (both market and stock) show a bottoming out in March/April and a reversal in trend, clearly indicating that the line of least resistance was now upward in direction. NOTES FOR THE TRADER Due Diligence: Do a final, thorough analysis of the individual stock you have decided to trade. This step would be similar to traveling down the runwaybut not lift offa final chance to change your mind before you pull the trigger and buy the stock. This final step must be completed by you, and you alone. Make this decision on your ownits your money. A military friend of mine, U.S. Navy Commander (Ret.) Dennis Kranyak, compares this approach of Livermores to the steps the U.S. Marines follow before they select a beach to assault. They study all the factors on all the possible beaches. They analyze all these factors as carefully as they can with the full knowledge that the assault will not be perfect, no matter what the analysis reveals to them. There will always be unknown factors, the main one being the unpredictable human factor in assaulting a beach or playing the stock market . . . there is always the human factor to consider. Here are some Livermore Laws: Wait until the preponderance of evidence is in your favor. Use Top Down Trading. Be patient! Jesse Livermore SUMMARY Tandem Trading, the use of sister stocks, was one of the great secrets of Livermores trading techniques and remains just as valid today as it did in years gone by. This technique is an essential element in both Top Down Trading and in the maintenance of the trade after it has been completed. Livermore never looked at a single stock in a vacuumrather, he looked at the top two stocks in an Industry Group and did his analysis on both stocks. Understanding Top Down Trading, including Tandem Trading or sister stock trading, is essential to the successful use of the Livermore Trading System. The overall conclusion was simple: both stocks had to have the same pattern to initiate a trade in that group. Never look at only one stocklook at twotrack two. Why? Because stocks in the same group should always move together. Tracking two stocks instead of one adds a great confirming psychological dimension to your trading. You will discover when you visualize two stocks moving in unison that they confirm the movements of each other. It is twice as hard not to follow the correct signal when you see with your own eyes that the sister stocks actually move in tandem and therefore give you the absolute confirmation. It was this Tandem Trading technique that allowed Livermore to police his investments properly. Once the investment was made, Livermore heightened his vigilance and continued his due diligence by daily observation of the two stocks. For Livermore, the evidence, the clues, the truth were always in the market itselfquite visible if a person knew how to read them, the way an experienced forensic investigator examines the details of a crime sceneclues become obvious to him that are visible to no one else. The answer lies in the market factsthe challenge for the trader is to properly interpret the facts that appear. He told his sons: Its like being a great detective working on a great case that never endsyou never know it all! Several other Livermore principles are at work in his Top Dawn Trading method and were part of his checklist: Always trade with the trend. A trader should always have the trending wind at his back. Find the market that the stock is traded in (Dow, S&P, Amex, Nasdaq) and observe how the overall market is trading. For example, examine the line of least resistance or the trend of the Nasdaq, if you are interested in trading Microsoft (MSFT) or Intel (INTC). Or examine the Standard and Poors 500 (SPYS) if you are interested in trading the top 500 stocks in America. The ultimate objective in the trade is to have the overall market trending in the same direction as your trade. You can trade short or long as long as it coincides with the current trend at the time. Livermore never cared which side of the market he was onshort or longit was all the same to him. Only play the leading stocks in the leading Industry Groups. In other words, only follow the leaders. CALLING THE TOPS OF MARKETS USING INDUSTRY GROUPS AND TOP DOWN TRADING Livermore was asked many times how he called the top of the overall market, as he did in 1907 and 1929 when he made millions by going short. He did it using his Top Down Trading System along with his Industry Group Analysis method. This gave him the clues that enabled him to call these major changes in market direction. It was Livermores experience that stock-group behavior is an important key to overall market direction, a key known by Wall Street, but ignored by most traders, whether they are big or small. He believed the groups often provided the key to changes in trends. As the favored groups of the moment became weaker and collapsed, a correction in the overall market was usually on the way. Note: The same thing happened in the 2000 market collapse. The leaders flipped and fell first, and the others followed. |
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