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This was a mistake as far as Livermore was concerned because the trend lines can give the trader a clear picture of the momentumUNDERSTANDING TREND LINES AND PIVOTAL POINTS Trend lines are one of the oldest tools used by technical traders. They are easily charted, readable, reliable and very useful. They easily can be employed in conjunction with the Livermore Theory. The key is to recognize whether a line shows a true change in the basic trend of a stock or simply a normal reaction. The trend lines are formed between the relative highs and the relative lows of a stocks trading pattern. They form a channel within which the stock trades. This channel supplies the trader with a picture of the support and resistance channel. Support is usually identified by a previous reaction low causing the stock to be supported at this old low. Resistance is the opposite of support. It represents a price level or an area above the market where selling pressure simply overpowers buying power and the stock is turned back or repelled at this level, retreating usually back into the trough. Usually, when the trend lines are broken, the stock will continue to trade in the direction of the breakout. It should be noted that this can be in either direction. These trend lines can be formed and identified in all time frames. We are using 10 days, and a 6-month time frame for the same stock. All these various time frames can be successfully traded. The volatility of the stock is in direct proportion to the timingthe shorter the time frame, say one day, the more volatile the stock movements. Because trend lines have been around forever and are very simple to use, many traders do not spend a lot of time and energy on them. This was a mistake as far as Livermore was concerned because the trend lines can give the trader a clear picture of the momentum behind a stockup, down, or sideways, and they clearly define the channel within which a stock movesthis makes it far easier for the trader to see when the stock breaks out and when it breaks downout of the channel. It should be noted that Livermore did not use charts. He used his complex mathematical formulas (explained in the Secret Market Key section of this book (Chapter 11)) to achieve the same effect. Charts now are used to illustrate the Livermore Trading System details because they are easily available to the trader and have become far more accessible and improved today. As stated, the Reversal Pivotal Points are really the beginning and end points of trend lines. They appear when the trend is reversing. Figure 4.11 of the Nasdaq clearly shows a Reversal Pivotal Point at the arrow in November/December. Figure 4.12 of Best Buy shows a clear Pivotal Point in November/December. Continuation Pivotal Points, on the other hand, indicate that a new formation is appearing, although the direction has not yet been established. When these form, the trader has a terrific opportunity to wait and see what is next in store for the stocks. The Continuation Pivotal Point for Merrill Lynch appears in August/September and goes on to climb higher in Figure 4.13. Figure 4.14 shows Verisign with two Continuation Pivotal Points in November/February and June/ December. With a little practice, the ordinary trader will soon become skilled at drawing in these trend lines. The results, with patience, can be outstanding. When the Continuation Pivotal Points form, the trader must battle with himself not to anticipate the break-out by superimposing his own logic onto the situation. He must sit on his hands and wait for the confirmation that the break-out is valid and the direction obvious, even if he misses a few points on the trade. Figures 4.15 and 4.16 show how trend lines appear and can be drawn in a trending stock. The Livermore trader wants to seek out trending stocks with low volatility. The first chart, Merrill Lynch, is a trending stock and can be fairly easily read and traded on its pivotal points. The second chart, Microsoft, is a much more choppy and confused stock with no trend or clear direction. OTHER RECURRING PATTERNS Spikes and One-day Reversals Livermore was very wary of any aberration in the price or volume of a stock that he was tracking. Sometimes, the price would spike, accompanied by abnormally heavy volume of at least a 50 percent increase over the average daily volume. This often led to what he named One-Day Reversals or trading climaxes. They often were like a red flag warning of a change of trend. An aberration to him was any strong deviation from what was normal for the stock. He considered a spike in the stock price, high volume, as well as low volume, all aberrations, deviations from the norm. To him, these were possible danger signals, and often signals to exit a trade. The spiking pattern is often a result of pent-up energy in the stock, as in a pressure cooker. It is the follow-through action of the stock that then becomes important to observe as to what the next action will be. These spikes are often a reflection of exhaustion in the stocks momentum, and they often appear at the end of a move, like a last gasp. They can provide a terrific signal for the observant, savvy trader. The One-Day Reversal (shown in Figure 4.17) was a strong signal for Livermore, a signal that made him sit up and take notice. A One-Day Reversal occurs when the high of the day is higher than the high of the previous day, but the close of the day is below the close of the previous day, and the volume of the current day is higher than the volume of the previous day. This scenario was a potential screaming danger signal to Livermore. Why? Because all during the stocks rise, it followed the trend, the line of least resistance, it had only normal reactions. Then, all of a sudden, it had an abnormal, sudden aberrant reaction . . . it moved 15 points in only 3 days on heavy volumeit has broken its pattern! Even though the stock may have risen in price, this is not a positive sign, but rather a danger signal that must be heeded! It was Livermores belief that if you had the patience to sit with the stock all during its rise, now after the one-day reversal pattern appears you must have the courage to do the right thing and acknowledge this danger signal. You must now consider selling the stock, because you have received a valid warning signal. Break-Out from a Consolidating Base Stocks sometimes take time to consolidate and build a base before continuing their movement. This base allows time for the stock to take a breather and a chance for the sales and earnings to catch up to the new valuation of the stock. In many ways, it is similar to a long Continuation Pivotal Point in function, although the formation looks different, and it usually takes longer for the Consolidating Base to form. When the Consolidating Base occurs, the same patience must be applied to the situation as required with the Continuation Pivot Pointdont anticipaterather wait for the stock to tell you by its action which direction it is going to go. A common pattern of a Consolidating Base is called the saucer pattern. This pattern shows a slow, often long-term consolidating bottom that forms a kind of extended gradual change in trend as it develops into full maturity. To recognize this pattern, the trader must see a clear arc with tight trading ranges at the nadir, or bottom, of the arc. A good trader can easily see the three boxes in Lucent Technologies. These boxes are really consolidations, each at a higher level. As stated, the pattern here in Figure 4.19 is very similar to the Continuation Pivotal Points pattern, where the buyers and the sellers are about equal in power. The stock lags along, or languishes and consolidates, waiting for the next move. These extended consolidations often come at the end of long market declines or advances. But the key rule still applies: do not anticipate the next movewait pa tiently for the market to tell youto confirm the movement either up or down. Break-Out on New High (or Low) Livermore was one of the first people to realize that stocks breaking out to new highs often took off from there and had astounding runs. Large profits can be derived from this simple fact. As stated by Livermore: Often in the stock market people do not see what is right under their noses. The thing with Livermores genius was that he observed things like Industry Group movement, Pivotal Points, and break-outs to new highs, and so was able to incorporate these factors into his trading system. Although others may have observed the same or similar things, they did not necessarily use this information in their trading. In fact, you will find that most traders have no real consistent proven system.They often depend on tips, instincts, analysts, brokers, friends . . . even astrologers. Livermores logic was always simple and to the point. New highs or new low break-outs were always good news for Jesse Livermore. Why? For him, they meant that the stock had pushed through the overhead resistance or underlying support and was very likely now to advance. The theory behind heeding this pattern was that Livermore had observed that people do not want to sell their stocks for a loss. So, if they missed selling on the high, which happened to the bulk of investors, they would sit with the stock through thick and thin and, when it rallied, if it did in fact rally, and proceeded to get back to the old high, they would dump their stock to recoup their losses. So, when the stock broke out to new ground above the old high this meant to Livermore that all that old overhanging stock was now cleared out of the way. This meant clear sailing ahead, in most cases. So, he was in effect buying the stock when the majority of people had sold theirs and when the stock was in position to make a new run. Conversely on the short side, new lows mean people have given up on the stock and are now dumping it, throwing it overboard to get whatever they can for it. This often leads to a rapid fall into oblivion, or the stock proceeds to form a climax bottom, similar to the One-Day Reversal that we have already discussed, only on the downside. The stock will most often finally bottom out and form a Reversal Pivotal Point, and a new upward trend will begin at this juncture. At this point, the astute trader may want to reverse his position and move to a long trade. Any trader will tell you that this sounds simple, but is difficult to do because the natural instinct is to buy cheap and sell dear. In this case, the Livermore Trading System instructs the trader to do the opposite and pay top dollar for a stock that has broken through the old high and now has a clear open field to run. This shows a New High Break-out Formation that appeared on a regular basis to Livermore in numerical form. Charts have been used for expediency. Why these formations repeat themselves is unknown. Livermore attributed this repetition to human nature: All through time, people have basically acted the same way in the stock market as a result of greed, fear, ignorance, and hopethat is why the formations and patterns recur on a constant basis. The patterns the trader observes are simply the reflections of human emotional behavior. IMPORTANCE OF VOLUME From the beginning of his trading career, Livermore was keenly aware of the importance of volume. Volume is a key factor in recognizing true Pivotal Points and other recurring patterns. It was obvious to Livermore that as the volume drastically changed in a stock, it was a clear aberration or deviation from the normal behavior of the stock. But was the volume accumulation or was it distribution? Livermore was an expert at detecting distribution. He had formed a strong opinion on that subject, because he knew how stocks were distributed by the pool runners of his day. The pool runners, experts like Livermore, were often charged with distributing the stock of the insiders who had formed a pool with their own stock for the purpose of controled distribution. How did the pool runners do it? The same way as they do it today. Stocks were never distributed on the way up . . . they were distributed on the way down. The reasoning was simplepeople will not take their losses when they should. The public will hold on to their stock as it drops and wait until it rallies back to the price where they bought it, so they can sell it. This is why so many stocks falter as they rally back to the old high. The people who bought at the high are now selling to get their money backbecause they got a serious frightand are now happy to recoup their losses. To the astute trader, a change in volume is an alert signal. It almost always means that there is something afoot, a change, a difference, a possible aberration. A serious change in volume always caught Livermores attention. He would ask himselfwas it the volume leading to the blow off, setting the stage for a decline, or was it a real interest in the stock, was it being accumulated getting ready to be driven higher? Livermore never spent any time looking for the reason why the stock was attracting a lot of volume. He simply took it as an axiom that volume was an alert signal. It was happening, that why was enough for him. He knew that the actual reasons why would be revealed later when the chance to make money was gone. Conversely, if there is heavy volume, but the prices stall and do not go up and make new highs, and there is no strong continuation of the current move, beware. This is often a strong clue, a warning, that the stock may have topped out and the accumulation is over and the stock is now going through a distribution phase. Note: The end of a market move is usually pure distribution, as stocks go from strong hands into weak hands, from the professionals to the public, from accumulation to distribution. It is often a market move by the promoters of the stock, a deception, to trick the public, who view this heavy volume as the mark of a vibrant, healthy market going through a normal correction, not a top or a bottom. This last gasp of heavy volume also provides a great opportunity to sell out any illiquid or large holdings. Livermore knew it was foolish to ever try to catch the tops or the bottoms of the moves. It is always better to sell large holdings into an advancing strong market when there is plenty of volume. The same is true on the short side, you are best to cover the short position after a steep fast decline. Livermore was always on the alert for volume indications as key signals at the end of a major move, either in the entire market itself or in an individual stock. Also, he observed that at the end of a long move, it was not uncommon for stocks to suddenly spike up in a straight shot with heavy volume and then stop and roll at the top, exhausted. Then they would retreat, downwardnever to make a new high before the onslaught of a major correction. As discussed before, there are two main trading systems available to the trader. The first is for those who believe that the stock market is a well designed rational, logical arena, for buyers and sellers to meet who buy and sell on what they feel is the fundamental value of a stock. These traders or investors believe that the stock market price is reflective of such things as a companys earnings performance, cash flow, balance sheet, and factory capacity, as well as future marketing prospectsearnings and sales. These fundamentalists try and factor in the myriad reasons why a stock should earn more or less and therefore predict that the price will go higher or perhaps lower in the futurebecause it reflects the stocks earnings potential and overall performance. Put simply, these types of traders and investors believe the stock market is an orderly place and the price of a stock is based on logical deductive reasoning. If the market moves against them, they simply conclude that they have misanalyzed the situation or not accounted for all the factors in a proper manner. The other group, which included Jesse Livermore, believed that the stock market is made up of human beings subject to human frailties. Livermore believed that most human behavior in the stock market was based on emotions, not logic, and people mostly acted in the market out of emotions rather than considered and deliberated reason. Therefore, he believed that a trader had to capitalize on the emotionalism of the market and ride along with that tide, not fight against it or try to explain it. This theory is commonly called technical analysis, which involves the use of charts, pattern recognition, or mathematical algorithms to try and forecast the future price direction of the stock market as well as individual stocks. A major factor in technical analysis is the belief that all the major factors that influence the price of a stock, the basic information such as political events, natural disasters, personnel shake ups, earnings reports, and other psychological factors are absorbed and quickly discounted in the actions of the actual market itself. Stated differently, Livermore believed the effect of all these external factors will show up quickly in the action of stock itself, primarily in the price movement. Therefore, the answer will appear in the chart itself. So, the trader should concern himself with what is happening not trying to predict what will happen! Stock prices are determined in a way similar to an open auction, in which an item is worth whatever a person is willing to pay for it at that time. This is not an easy concept for most people to grasp. How can a stock be worth $20 at noon and $15 at two oclock? After all, its the same stock. The trader soon learns in the stock market that a stock is worth what a buyer will pay for it at any given moment. One of Livermores favorite books was: Extraordinary Popular Delusions and the Madness of Crowds by Charles Mackay, first published in 1841. This book describes John Law and the Mississippi land bubble and the seventeenth-century tulip craze when a single tulip bulb sold for more than four oxen, eight pigs, twelve sheep, two hogsheads of wine, and much more. This was also a favorite book of Bernard Baruch, a fabulous stock trader and close friend of Livermores who also was one of the few people that did well in the crash of 1929. In the final analysis there are only two pieces of information that a trader should look atthe price (high, low, close) of a stock and the volume (amount of shares traded). Remember, at the end of a day of trading, everything boils down to only these two factorsprice and volume. All of the emotion is gone, all the guesswork disappears. The key information is always available to all the traders at basically the same time, yet some traders make money while others lose. It was Livermores belief that the answers were always present in this factual information. If they are not clearly discernable to the trader, he should refrain from trading until they are clear. Why a stock or the stock market itself acted as it did was usually too vast a subject to study, too complex for any person, computer, or system to analyze. Many technical traders place little importance on volumenot so with Jesse Livermore. The study of volume was a key element to be carefully analyzed at critical moments of a stocks life and history. Livermore believed that anyone who is inclined to speculate should look at speculation as a business and treat it as suchnot regard it as a pure gamble. He was convinced that speculation is a business in itself, and those people engaging in that business should determine to learn and understand it to the best of their ability with all the informative data available through technology. Livermore once said to a friend: In the forty years which I have devoted to making speculation a successful business venture, I have discovered and still am discovering new rules to apply to that business. |
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