TRADING UNIVERSITY – Start

Book Review: How to Trade in Stocks by Jesse Livermore

This is a book written by Jesse Livermore which was published in 1940, with new material added by Richard Smitten. The full title of the book is “How to Trade in Stocks: The Classic Formula for Understanding Timing, Money Management, and Emotional Control”.

TRADING METHODOLOGY

Top Down Trading

Market – Check the current overall market direction (i.e. the line of least resistance)
Industry Group – Check the specific industry group to make sure it is in line with the market direction.
Sister Stock – Check the stock and the Sister Stock to make sure they are moving together (tandem trading).
Stock itself – Do due diligence on the stock itself.
Pivotal Point – Make sure that you are buying at a crucial Pivotal Point and use this as the spot to establish your exit point if the trade goes bad

Go with Strongest Industry Groups

Understanding industry group action is essential to successful trading.
Why Industry Groups move together

If the basic reasons are sound why U.S. Steel’s business should come into favor in the stock market, then the rest of the steel group should also follow for the same basic reasons. This, of course also works for the short side of the market — when a group goes out-of-favor for basic reasons it will include all the stocks in that industry group.
Book note: The only exception is where a single stock may make up over 50% or more of the total sales of the group, then the rest of the group must follow this stock.

Stay away from weak groups!

The most intelligent way to get one’s mind attuned to market conditions and to be successful is to make a deep study of Industry Groups in order to distinguish the good groups from the bad: get long of those which are in a promising position and get out of those Industry Groups which are not.
Just as I would avoid the weak stocks in the weak industries, I would favor the strongest stocks in the strongest industries [my note: herd behaviour would be more prominent in the most visible industries and stocks.].

… stocks in [the same] industry groups often top out at the same time, as new groups move in to take their place. It is the overall trend of the leading groups that I watch.
Book note: Calling the tops – when the market turned in 1907 and 1929, the leaders rolled over first.

Tandem Trading

… stocks in the same group always move together. Tracking two stocks adds a great confirming psychological dimension to your mental abilities, when you can visualize that they move in tandem and 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 absolute confirmation.

Trade the Market Leader

Confine your studies of stock market movements to the prominent issues of the day, the leaders. It is where the action is — if you cannot make money out of the leading active issues, you are not going to make money out of the stock market.
I also believe in trading the market leader, go with the most powerful stock in the group – don’t look for the bargain, the weak sister, go with the leader, the anchor, the strongest stock in the group. Also note that this may not always be the conventional leader of the group. Occasionally, a smaller, well-managed stock in the group will assume leadership, perhaps with a new product, and 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.

Investigate Before you Leap

… no person can succeed in the stock market unless he or she acquires a fundamental knowledge of economics and thoroughly familiarizes himself with conditions of every sort — the financial position of a company, its past history, production capabilities, as well as the state of the industry in which the company is engaged, and the overall general economic situation.
In the end, it is earnings — profits, and profit potential that moves stock, not emotions, like hope and greed.
In the final analysis, it is profits, real and imagined, that eventually drive the price of stocks and remember that reality will always eventually set in to produce a final conclusion for the industry group and any particular stock.

TRADING TECHNIQUES

Trade only on Pivotal Points

Pivotal Points are a timing device. I use them to get in and out of the market.
One of my most important points in buying a stock was to try and buy as closely as possible to the Reversal Pivotal Point or the Continuation Pivotal Point… If the stock pulled away from the Pivotal Point in the opposite direction of my purchase I would automatically sell. Once in the green I was totally relaxed and just observed the stock’s movements in total calm and did nothing until it was time to close the trade.
The key to my later theory of trading is to trade: only on the pivotal points.
By correctly catching the Pivotal Points it enabled me to make my initial purchase at the right point so that I had an entry point at the right price from the beginning of the move. This insured that I was never in a loss position [… because I was ‘in profit’ from the beginning of the trade], and I could therefore ride out the normal stock fluctuations without risking my own capital.
Every time I lost patience and failed to await the Pivotal Points and fiddled around for some easy profits in the meantime, I would lose money.
If you buy before the Pivotal Point is established then you may be early. This is dangerous because the stock may never form a proper Pivotal Point to clearly establish its direction. But you must be careful — if you buy more than 5% or 10% above the initial Pivotal Point, then you may be late. You may have lost your edge because the move is already well under way.

Reversal Pivotal Point

Definition: A change in basic market direction — the perfect psychological time at the beginning of a new move, it is a major change in the basic trend.
Reversal Pivot Points are almost always accompanied by a heavy increase in volume, a climax of buying, which is met with a barrage of selling — or vice-versa. Increased volume is an essential element in understanding Pivotal Points — it must be present to confirm the Pivotal Point. This battle, this war, between buyers and sellers causes the stock to reverse its direction, top out, or bottom out in a decline. It is the start of a new direction in trend for the stock. These important confirming volume spurts often end the day with a 50% to 500% increase in the average daily volume of the stock.
Reversal Pivotal Points usually came after long-term trending moves. This is one of the reasons why I always felt patience was so necessary for success in catching the big moves. You need patience to be sure that you have identified a true Reversal Pivotal Point of a stock.
To confirm if a Reversal Pivot Point had occurred, look at the industry group, and at least one other stock in the group, to see if it had the same pattern.

Continuation Pivotal Points

Definition: A consolidation where the stock pauses in its ascent. It is usually a natural reaction of the stock.
Usually occurs during a trending move as a natural reaction for a stock in a definite trend.
This is a potential additional entry point in an ongoing move, or a chance to increase your position, providing the stock emerges from the Continuation Pivot Point, headed in the same direction as it was before the correction.
Do not chase a stock if it gets away from you — let it go. I would rather wait and pay more after the stock had regrouped and formed a new Continuation Pivotal Point, because this Continuation Pivotal Point provides a confirmation and insurance that the stock will most likely continue with its move. It gives a stock a chance to take a breath and consolidate often allowing the stock’s ratio of earnings and sales to catch up to the price of the stock.

I also believe that often the largest part of a stock movement occurs in the last two weeks or so of the play. I call it the — Final Markup Phase — the same thing applies for commodities.

Buy on Breakouts [book note]

… when I see by my records that an upward trend is in progress, I become a buyer as soon as a stock makes a new high on its movement, after having had a normal reaction.
Stocks were never distributed on the way up… they were distributed on the way down. The reasoning was simple — people will not take losses, 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. That 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 back — because they were scared — they got a fright — and are happy to get their money back.
This is one of the reasons why Livermore bought stocks on new-high-breakouts. Simply stated, with a new high breakout, there was most likely no stock overhanging the market, waiting to be sold on the uptick, it was usually clear open air above the old high, once the stock broke out into clear skies.

Beware of Danger Signals

I always looked for aberrations in the market. An aberration to me was any strong deviation from what was normal for the stock… To me these were possible danger signals, and often a signal to exit a trade.
Abnormal Reaction

An abnormal reaction is a reaction in one day of 6 or more points from an extreme price made in that same day.
The next morning it extends its reaction another point or so, and then once more starts to advance, closing very strong. But the following day, for some reason, it does not carry through.

Stock not Performing as Expected after Pivotal Points

But bear in mind in mind when using Pivotal Points in anticipating movements, that if the stock does not perform as it should, after crossing the Pivotal Point, this is an important danger signal which must be heeded immediately.

One Day Reversal
1. the high of the day is higher than the high of the previous day, but
2. the close of the day is below the close of the previous day [the close, not the low], and
3. the volume of the current day is higher than the volume of the previous day.

A One Day Reversal occurs when
I was very wary of price spikes accompanied by abnormally heavy volume of at least a 50% increase versus the average. This often led to “One Day Reversals”.

Change in Volume
- At the beginning of the move you will notice a very large volume of sales with gradually advancing prices for a few days.
- Then what I term a “Normal Reaction” will occur. On that reaction the sales volume will be much less than on the previous days of its advance.

A change in volume is an “alert signal”. Livermore never searched for the reason “why”. It was “happening” that was “why” enough for him. The reasons would be revealed later when the chance to make money was gone.
What is considered normal volume?

Track Money Flows

I have observed that the principle power of a bull market is purely money, the availability of money, and the real attitudes and emotions of men and women and whether these people are inclined to buy or sell stocks — I have always tracked the money flow as well as I could.

MONEY MANAGEMENT

Rule #1: Probe System

Factor #1: Do not take your entire position all at once.

It is wrong and dangerous to establish your full stock position at only one price.

Factor #2: Wait for confirmation of your judgment — pay more for each lot you buy.

The basic logic is simple and concise: each trade, as it is established toward the total 1000 share position, must always show the speculator a profit on his prior trades. The fact that each trade showed a profit is living proof, hard evidence, that your basic judgment is correct in the trade. The stock is going in the right direction — and that is all the proof you need, and conversely if you lose money… you know immediately that your judgment is wrong.

Factor #3: Establish in your mind the total amount of shares you want to purchase, or specify the amount of dollars you are willing to commit, before you begin the trade.

… you must first decide how many shares you want to trade. For example, if you want to purchase 1000 shares as the full final position do it like this: Start with a 200 share purchase on the pivot point — if the price goes up then buy an additional 200 shares, still within the pivot point range. If it keeps rising, buy another 200 shares. Then see how it reacts, if it keeps on rising or corrects and then rises you can go ahead and purchase the final 400 shares.
[my note: using number of shares is better here because as the price rises, you spend more at each purchase meaning you put a bigger bet as you get more confirmation that your bet is correct. Whereas value investing should use the amount of dollars method because as the price drops, you buy more shares with the amount of dollars meaning you are increasing your bet size as the stock becomes more of a bargain. The key difference here is that the Livermore way buys on the way up, and value investing buys on the way down.]

Pyramiding

… I have tried to establish my main position at the beginning, at the initial Pivotal Point, and then increase it at what I call the Continuation Pivotal Point — providing the stock comes out of the consolidation with strength. By this I mean the trader must wait until the stock has proven it is going to break out on the strong side of the Continuation Pivotal Point…
The final time a trader can pyramid is when a stock breaks out to a clear new high on heavy volume this is a very good sign because it most likely means that there is no more overhanging stock to stop the progress of the stock for a while.
Pyramiding is a dangerous activity… for the further a stock gets extended in its rise or decline the more dangerous the situation becomes. I tried to restrict any serious pyramiding to the beginning of the move. I found it not wise to enter a pyramiding action if the stock was far from the base — better to wait for the Continuation Pivotal Point of the breakout from a new high.

Rule #2: Bucket Shop Rule

… I learned it in the bucket shops where I worked all my trades with 10% margin. I was automatically sold out by the bucket shops if the loss exceeded the 10% limit. The 10% loss rule became my most important rule for managing money. It is also a key “timing” rule… since it automatically sets the time to exit a trade.
Remember — a speculator must set a firm stop before making the trade and must: never sustain a loss of more than 10% of invested capital!
I never asked for the reason the fact that it had dropped was reason enough to get out.
Another reason for buying on the Pivotal Point is that it always gave a me clear point of reference… I then had a reference point to select as a point for my stop, where I would close my trade if things went against me.
I have observed many times that people often become ‘involuntary investors’. They buy a stock that goes down, and they refuse to sell and take their loss. They prefer to hold on to the stock and hope that it will rally eventually and climb back up. This is why the 10% rule is essential.
I later in life developed my theory on the importance of the dimension of time in trading the stock market. By moving quickly, I avoided those situations where a stock just sits in a channel for a long period of time and your money becomes inactive. Like a person who owns a retail store and one item just sits on the shelf, stagnant. The smart retailer “clears out” that item, and uses the money to stock an item that sells, an item that is in demand. The same is true of the stock market, keep your money invested in the leaders, the stocks that are moving.

Rule #3: Keep a Cash Reserve

The successful speculator must always have cash in reserve.
There is a never ending stream of opportunities in the stock market, and if you miss a good opportunity, wait a little while, be patient, and another one will come along.
This desire to “always be in the game,” is one of the speculator’s greatest enemies in managing his money.
Often money that is just sitting can later be moved into the right situation at the right time and make a vast fortune – patience – patience – patience is the key to success not speed – time is a cunning speculator’s best friend if he uses it right.

Rule #4: Cut your Losses — Let your Profits Run

Stick with the winners — let them ride until you have a clear reason to sell.
When I was in profit on a trade I was never nervous… Why?… I was simply “using the track’s money — the stock market’s money,” and if I lost all this profit — well then I had lost money I never had in the first place.

Rule #5: Take Money Off the Table

A speculator should make it a rule each time he closes a successful deal to take 50% of his profits and lock this sum up in a safe deposit box. The only money that is ever taken out of Wall Street by speculators is the money they draw out of their accounts after closing a successful deal.
There is no better time than after a large “win” on a stock. Cash is your secret bullet in the chamber, keep a cash reserve.
The single largest regret I have ever had in my financial life was not paying enough attention to this rule.

TRADING PHILOSOPHY

Why Technical Analysis Works

All through time, people have basically acted and re-acted the same way in the market as a result of: greed, fear, ignorance, and hope – that is why the numerical formations and patterns recur on a constant basis.
There is nothing new on Wall Street or in stock speculation. What has happened in the past will happen again, and again, and again. This is because human nature does not change, and it is human emotion, solidly built into human nature, that always gets in the way of human intelligence.

Wait for the Right Moment

It’s not the thinking’ that makes the money — it’s the sitting’ and waiting’ that makes the money.
There are times when money can be made investing and speculating in stocks, but money cannot consistently be made trading every day or every week during the year. Only the foolhardy will try it. it just is not in the cards and cannot be done. To invest or speculate successfully, one must form an opinion as to what the next move of importance will be in a given stock.
Almost invariably the vast majority have commitments on the wrong side when the broad trend swings under way. The speculator who insists on trying to profit from daily minor movements will never be in a position to take advantage of the next important change marketwise when it occurs.
Wait until the Preponderance of Evidence is in your Favor. Use Top Down Trading. Be patient!
… analyze in your own mind the effect, marketwise, that a certain piece of news which has been made public may have in relation to the market. Try to anticipate the psychological effect of this particular item on the market. If you believe it likely to have a definite bullish or bearish effect marketwise, don’t back your judgment until the action of the market itself confirms your opinion.
It’s okay to mentally anticipate the action of the market, or a stock, but take no action until the market has confirmed that you are correct, by its action: don’t anticipate market moves with your hard earned cash… Often the market will go contrary to what a speculator has predicted. At these times the successful speculator must abandon his predictions, and follow the action of the market. A prudent speculator never argues with the tape, remember: Markets are never wrong — opinions often are.
Make sure that you have placed as many factors in your favor as possible and never rush into any trade, take your time, there will always be another play.
Never let yourself become discouraged by the fact that your securities are moving slowly. Good securities in time appreciate sufficiently to make it well worthwhile to have had patience.

Never Average Losses

It is foolhardy to make a second trade, if your first trade shows you a loss.
Just because a stock is selling at a high price does not mean it won’t go higher. Just because a stock has fallen in price does not mean that it won’t go lower. I never buy a stock on declines, and I never short a stock on rallies.
… each succeeding purchase must be at a “higher price” than the previous one. That same rule should be applied in selling short. never make an additional sale unless it is at a lower price than the previous sale. … The fact that your trades “do” show you a profit is proof you are right.
Experience has proved to me that the real money made in speculating has been in commitments in a stock or commodity showing a profit right from the start.
… when your broker calls you and tells you he needs more money for a margin requirement on a stock that is declining — tell him to sell out your position. Take your losses quickly and get out. Never meet a margin call, and never average losses.

Focus rather than Diversify

Do not have an interest in too many stocks at one time. It is much easier to watch a few than many.
[Following the current leaders] … will also keep your trading universe small and controllable, so you can focus and trade the stocks with the greatest potential.

Don’t Seek Explanations for Price Movements

Certainly success with this plan depends upon courage to act and act promptly when your records tell you to do so. There is no place for vacillation. If you are going to wait upon someone else for explanations or reasons or reassurances, the time for action will have escaped.
My theory is that behind these major movements is an irresistible force. That is all one needs to know. It is not well to be too curious about all the reasons behind price movements… Just recognize that the movement is there and take advantage of it by steering your speculative ship along with the tide.

Keep your Funds Liquid

Keep your funds liquid and working for you! Perhaps nothing has so interfered with the proverbial poor success of the public in the investment markets as this fact — that it does not keep its investment and speculative funds in proper circulation. The public is usually in a permanent loaded-up or tied-up condition, with no cash or buying power in reserve.
Remember, when a merchant has part of his capital “frozen” out of circulation he must then make all his profit on the capital that is left not “frozen” this hampers and hinders him because that “unfrozen capital” must often work twice as hard to make up for the “dead-frozen” capital which yields little or nothing.
Listless Drifters are stocks that do not move in the desired manner and simply tie up a stock market trader’s capital as they hang out there drifting in no man’s land. Whenever I have had to depend on hope I have always felt exposed to danger.
I have discovered that I cannot afford to trade in anything but live stocks, stocks that are leading the pack, stocks that have inherent energy.
I would wait days, weeks, months, for the stock to position itself at the spot I thought most opportune, in other words the perfect moment to make my purchase — when every factor was in my favor… if it did not move as I believed it should move within a few days or what I considered a reasonable time, say a week or two, I would then sell out the position… even if the stock did not decline.
I have two stops in mind when I enter a trade, I have a “price stop” and I have a “time stop”

I will not stay with any trade more than a few points if it moves against me; and
I will not stay with a stock position for more than a few days if the stock does not perform as I expect it to perform.

Establish a Profit Target – a Risk Reward Ratio

It was my experience that few investors established a risk/reward ratio before they entered a trade. It is essential to try and do this, have a specific plan.
I wanted at least the opportunity of a 10 point gain in any stock I invested in.

Cash Out if Unsure of Trend Changes

I always wanted to trade along the Line of Least Resistance – The Trend, so I was generally moving along with the crowd, the herd, most of the time. It was when the ‘change in trend‘ started to appear the change in overall market direction that was the most difficult moment to catch and act upon. I always was hunting for the clues to the change.
But, I was always ready to separate myself from the popular thinking, the group thinking an go in the opposite direction, because I believed in cycles — like life they go up and down.
Do not be invested in the market all the time — there are many times when I have been completely in cash, especially when I was unsure of the direction of the market and waiting for a confirmation of the next move. In my later life, whenever I deduced that a change was coming, and I wasn’t sure exactly when, or how severe the change might be, I cashed in all my positions and waited.
To determine if I was right in my appraisal that a change in market trend was coming, I used small position probes, placing small orders… to test the correctness of my judgment.

OTHER POINTS

Interpreting News Events

First, I try to interpret their immediate and direct influence on the opinions and actions of stock traders with regard to a particular stock.
Second, I watch the actual stock quotes to detect how the news has influenced the buying and selling of specific stocks as a whole in that market industry.

Playing The Stock Market Game

I have found the study of Pivotal Points fascinating almost beyond belief. You will find a golden field for personal research. You will derive a singular pleasure and satisfaction from successful trades based on your own judgment. You will discover that profits made in this way are immensely more gratifying than any which could possibly come from tips, or the guidance of someone else.
The work of solving the puzzle was what always fascinated me. It was never the money it was solving the puzzle, the money was the reward for solving the puzzle.
The stock market is the greatest, most complex puzzle ever invented, and it pays the biggest jackpot.

Fear and Hope

And people become afraid when they start to lose money, their judgment becomes impaired.
And the unsuccessful investor is best friends with hope — and hope skips along life’s path hand-in-hand with greed and fear when it comes to the stock market. Once a stock trade is entered, hope springs to life.
In other words, there are millions of minds involved in the stock market, these minds form decisions based on the two main emotions in the stock market: hope and fear — hope is often generated by greed — fear is often generated by ignorance.
When stocks decline swiftly, and abruptly, they are being driven by fear. When they rise they are being driven by hope. If people are hoping a stock will rise they are slower to sell. If they fear the stock will decline they are usually fast to dump that stock. That is why declines produce faster, more abrupt market action.

Why Play the Short Side

But the stock market moves up roughly a third of the time, sideways a third of the time, and downward a third of the time. If you only played the bull-side of the market you were out of the action, and a chance to make money two thirds of the time.

How to Think Clearly

Getting out and waiting for the market to establish itself is very difficult while you are invested, because by being invested you will have an automatic bias toward the direction of your position.
That is why I often sold out all my positions and re-evaluated the market from a cash position. It cost me the commissions, but for me I viewed this as a small insurance premium cost toward my overall goal.

Keep Stress At Bay

Act in all ways to keep the mind clear and your judgment correct.
I did all I could to achieve this in my physical life by going to bed early, eating and drinking lightly, taking exercise, standing upright at the stock ticker, standing while on the telephone and demanding silence in the office.

Beware of Inside Information

Beware of inside information… all inside information!
There is only one way to achieve success in speculation — through hard work, persistently hard work.

LIVERMORE MARKET KEY

Filtering the Intermediate Oscillations

Now I can look back on those initial efforts and understand why they were not immediately fruitful. Having then a purely speculative mind, I was trying to devise a policy for trading in and out of the market all the time, catching the small intermediate moves. This was wrong, and in time I clearly recognized the fact.
What I wanted to discover was a method of recognizing what constituted the minor swings. I realized a market in a definite trend still had numerous intermediate oscillations. They had been confusing. They were no longer to be my concern.
I wanted to find out what constituted the beginning of a Natural Reaction or a Natural Rally. So I began checking the distances of price movements. First I based my calculations on 1 point. That was no good. Then 2 points, and so on, until finally I arrived at a point that represented what I thought should constitute the beginning of a Natural Reaction or Natural Rally.

Scope of the Livermore Market Key

The intent is to catch the major moves, to indicate the beginning and the end of movements of importance.
It should, perhaps, also be repeated that this formula is designed for active stocks selling above an approximate price of $30.

Key Price

But there is danger of being caught in a false movement by depending upon only one stock. The movement of the two stocks combined gives reasonable assurance. Thus, a positive change of the trend must be confirmed by the action of the Key Price.
When a recording point has been reached — that is, a move of 6 points average by each of the two stocks — I continue to set down in that same column the extreme price made any day, whenever it is higher than the last price recorded in the Upward Trend column or is lower than the last price recorded in the Downward Trend column.