 Wisdom of Jesse Livermore 8
Adam Hamilton
Archives
May 15, 2004
Legendary speculator Jesse
Livermore is surely one of the most fascinating characters in
all of financial-market history.
About a century ago Jesse Livermore
blossomed into one of the most celebrated speculators of all
time. He was trading heavily in the early decades of the 1900s,
a wondrous era to speculate in stocks. His renowned exploits
are still viewed with great awe and reverence by today's elite
speculators and his towering speculation wisdom will stand tall
for ages to come.
If you are interested in more
background information on Jesse Livermore and my reasons behind
writing this series of essays on the man's awesome speculation
wisdom, you may wish to skim the introduction of the first
essay in this series.
Mr. Livermore's exploits were
recorded in the greatest book on speculation of all time. Originally
published in 1923, it is called "Reminiscences of a Stock
Operator" and was written by a gifted financial journalist
named Edwin Lefevre. Mr. Lefevre penned the account as if from
the first-person perspective of a fictional trader named Larry
Livingston. As Lefevre had spent weeks extensively interviewing
Jesse Livermore, market historians are virtually unanimous in
viewing Lefevre's classic book as a thinly-disguised biography
of Livermore's trading life.
Today "Reminiscences
of a Stock Operator" is fondly read with awe by speculators
of all levels and abilities all around the globe. I have personally
read the book many times and I try to re-read it at least once
a year now. The speculation wisdom contained within these magical
pages is just awesome and truly priceless for all speculators
to digest.
If you are interested in speculation
and you haven't read this book yet you owe it to yourself to
buy it today at Amazon or Barnes & Noble. I can almost guarantee
that it will forever change you as a speculator and help you
soar to new heights of understanding of the game and achieving
real-world success.
Jesse Livermore's words and
experiences are so endearing and powerful because he presents
himself as just another mere mortal like you and I, with hopes,
fears, and frailties. He is brutally honest in critiquing his
own evolution as a speculator and thoroughly explaining his own
mistakes and the great wisdom they ultimately led to.
In this series of essays Jesse
Livermore's wisdom is presented chronologically from the book.
All the bold-faced passages below are his words directly out
of Lefevre's book, while the following normal text is my own
feeble thoughts and commentary attempting to pull Livermore's
wisdom a century into the future to today. Before every quotation
below, the chapter in "Reminiscences" from which it
is pulled is noted so you can quickly find it and dig deeper
by reading the valuable surrounding background context if you
wish.
I hope and pray that you find
Jesse Livermore's awesome wisdom as exciting and valuable as
I have!
(Chapter VII)
..."I never hesitate to tell a man that I am bullish or
bearish. But I do not tell people to buy or sell any particular
stock. In a bear market all stocks go down and in a bull market
they go up. I don't mean of course that in a bear market caused
by a war, ammunition shares do not go up. I speak in a general
sense. But the average man doesn't wish to be told that it is
a bull or a bear market. What he desires is to be told specifically
which particular stock to buy or sell. He wants to get something
for nothing. He does not wish to work. He doesn't even wish to
have to think."
Jesse Livermore, as always,
comes out with both barrels blazing while discussing the importance
of focusing on markets as a whole rather than individual stocks.
This is indeed one of the central themes of the entire book.
I suspect the reason that Mr. Livermore emphasizes this core
truth of speculation so much is because it is so contrary to
our natural inclinations as speculators. We tend to want to ignore
the markets as a whole and focus on the exciting story stocks,
always looking for the next future giant like Microsoft while
it is still in its infant stage.
Yet, if we spend so much time
focusing on individual stocks that our current understanding
of the big strategic market picture fades, we risk losing the
forest for the trees. If conditions are favorable in a forest
at a given time, if the temperatures are moderate and rain is
plentiful, all of the trees will grow. But if conditions are
unfavorable, such as during a long drought or wildfire season,
none of the trees will fare particularly well. The markets work
the same way.
During a bull market, most
stocks will ride the primary trend up to higher prices. A rising
tide lifts all boats. During a bear market, most stocks will
fall in price. Even folks adept at stock picking, if they are
fighting the primary trend, are not likely to achieve excellent
trades. Shorting stocks in a bull market or buying stocks in
a bear market, almost regardless of their individual stories,
is very risky and has a high probability of failure.
Never lose sight of the primary
trend in place, and bet with it rather than against it whenever
you can. If you can combine a solid understanding of the strategic
trends in force with carefully buying great stocks positioned
to leverage the markets' major movements, your odds of speculation
success multiply dramatically.
Interestingly, Livermore ties
his trademark macro view in with his legendary antipathy for
tippers, people who give stock tips. Since we are all searching
for that next elusive tiny stock that will blossom into a monstrous
corporate giant and make us fabulously wealthy, we have to be
very careful about where we get our information. As Livermore
rightly says, we all tend to want something for nothing, to be
told exactly what to trade rather than thinking for ourselves.
This desire renders us vulnerable to all kinds of unscrupulous
players, con artists, and promoters.
To fight this innate tendency,
make sure that you carefully cultivate multiple independent sources
of information that you trust, and even then carefully filter
all of this through your own observations, studies, and understanding
of the markets.
Never trade on information
from an anonymous or unaccountable source, such as some random
spam e-mail touting a stock, or some unknown poster on the Web
hiding behind a false name, or even a friend of a friend of a
friend. Always be wary of someone who appears to be just picking
stocks for the sake of picking stocks, with no strategic market
context offered. And if someone presents a case for a stock that
is just too good to be true, then it probably isn't true.
Good information sources, in
addition to being fully accountable for their info, only attempt
to pick stocks within the context of the already dominant primary
market trends. As Jesse Livermore wisely pointed out, almost
all trades will do well if they are congruent with the primary
trend already in force.
(Chapter VII)
... "When I am bearish and I sell a stock, each sale must
be at a lower level than the previous sale. When I am buying,
the reverse is true. I must buy on a rising scale. I don't buy
long stock on a scale down, I buy on a scale up."
This quotation leads off a
fascinating few pages in Reminiscences where Jesse Livermore
details the right way to open up a new speculative position.
Scaling into trades sounds simple, but it is an absolutely brilliant
strategy based on the psychology of trading, probability theory,
and our imperfect knowledge of the near-term future in the markets.
Scaling is essential to protect us from our own volatile emotions!
The natural tendency of speculators
is to avoid scaling all together. We study conditions, we start
getting excited as the stars seem to be lining up in our favor,
and when things finally feel right we want to pull the trigger
immediately and deploy 100% of our capital at once. I have done
this, you have done this, and pretty much everyone playing the
game has experienced this normal behavior sometime in their earlier
years of speculating!
Taking the big plunge however,
throwing out a whole line at once rather than gradually scaling
in, is extremely risky and not very prudent. First, the psychology
of speculation gets in the way. If conditions look so ideal that
a speculator is willing to consider betting everything at once,
then emotions will be running high. There is nothing like greed
and fear to cloud our minds as we ponder the markets and trading.
By trading all at once, the very real risk exists that the decision
will be much more emotional than rational. Emotional decisions
often lead to big losses.
Second, it is impossible for
us mere mortals to know exactly when a major tradable interim
top or bottom in a primary trend has arrived in real-time. Sure,
over the years our guesses of turning points during tops and
bottoms will become more accurate with experience, but no one
really knows until after the fact. The probabilities of consistently
picking the exactly ideal moment to trade every time are almost
zero. As such, anytime you are preparing to take a big plunge,
odds are your timing is less than ideal.
Scaling deftly short-circuits
harmful emotions and harnesses the laws of probability on the
side of the speculator when facing an uncertain near-term market
future. Scaling also spreads out risk and protects precious capital
from serious losses.
Scaling simply involves buying
a position in chunks over time rather than all at once. If you
want to buy a particular stock, for example, it is wisest to
decide how much total capital you are willing to risk in that
stock and then divide it by five ways or so. You initially take
a fifth of the capital you intend to ultimately deploy, and you
buy your position with it. After this first fifth is deployed,
you prudently step back and patiently wait and watch your initial
exploratory trade.
If you are going long in a
bull market, and your stock goes down after your initial scaling
purchase, then you were probably buying in too early in a correction.
Rather than taking a loss on your entire mass of capital allocated
to that stock, you only take a loss of a portion of your initial
fifth as the remainder remains safe in cash. If the stock moves
against you initially you can sell your initial fifth and get
neutral or wait it out as long as you have deployed a stop loss
on your position. Since you prudently scaled in, your initial
loss isn't a big deal and you live to trade another day when
conditions are more favorable.
Jesse Livermore wisely said
he would only scale up in a bull market, he wouldn't deploy another
scaled trade in a particular stock until he already had a profit
on his first lot. After his first exploratory position traded
higher, he would add the next chunk of capital and wait and see
what happened. When he had a profit on that too, he would add
another lot, and watch and wait. Eventually he would be fully
scaled in and riding with the primary trend.
Generally the ideal time to
buy with a primary trend is during pullbacks, which are typically
shaped like a V. The trick is to guess when the bottom of the
V pullback has been reached. Since we cannot know the market
future before it happens, scaling allows speculators to only
risk a moderate amount in trying to pick the bottom of the V.
If you buy in too early, your initial fifth suffers losses and
you sell or wait. If you buy in on the right side of the V however,
the proper one, all of your scaled trades quickly show profits
and soon you are fully deployed with all five fifths of your
capital allocated to the winning trade.
Thus, Livermore-style scaling
in with a trend provides great benefits to speculators. It short-circuits
emotions, since only a conservative fraction of capital is risked
at first and subjected to the capricious whims of greed and fear.
It greatly increases the probability of buying right after an
interim bottom, since the remainder of the original capital allocated
is only scaled in after the initial exploratory trades show a
profit. Finally, it reduces the amount of capital at risk until
the short-term trends are running in a speculator's favor once
again.
Rather than taking the risky
big plunge, it is wisest to scale in gradually to test the waters
and see if your market assumptions were right before you are
in over your head. This is a hard lesson to learn, as I think
we all have to suffer through big losses on big bets before we
understand the excellent wisdom inherent in scaling in. I know
I did.
(Chapter VII)
... "When it comes to selling stocks, it is plain that nobody
can sell unless somebody wants those stocks. If you operate on
a large scale you will have to bear that in mind all the time.
A man studies conditions, plans his operations carefully and
proceeds to act. He swings a pretty fair line and he accumulates
a big profit on paper. Well, that man can't sell at will."
The larger your position in
a given stock, the harder it will be for you to sell when you
are ready. If the buyers aren't there the day you wish to sell,
your sale will push a stock lower or even crash it and you will
end up losing much of your paper profits just in the process
of selling. Lots of folks think this kind of risk only applies
to very large players like fund managers, but it also applies
to individual speculators today as well.
The size of a trading position
in any stock is relative. While you almost certainly don't have
enough capital to affect trading in a monster stock like General
Electric, you may have enough capital to really move a smaller
stock. If you are involved in penny stocks, such as lightly capitalized
obscure technology or tiny junior gold stocks, then you really
have to consider these risks before deploying your trades. Even
before you buy you need to plan an exit strategy, and this includes
making sure the exit is large enough for you when you want out.
In order to avoid getting trapped
in a relatively hefty position in a small stock, it helps to
consider a couple things before you buy. First, examine the average
daily trading volume of your target stock in the recent months.
If the amount of capital you want to deploy approaches or exceeds
the daily volume multiplied by the share price, then odds are
you won't be able to get out all at once when you are ready.
Second, if you can live with
the risk that the exit is small and you probably won't be able
to liquidate your entire trade at once, then get psychologically
prepared to sell in pieces. Just as you scale in to new positions,
you can scale out of old ones. If you make sure that each of
your sales is modest relative to the prevailing daily volume
when you are ready to get out, then you increase your probability
of fully liquidating your trade without hammering the stock price
so much that your profits evaporate.
The smaller the stocks that
you are considering buying, the more important it is to plan
an exit strategy in advance so you know what you are getting
into. The size of any position is most important relative to
the trading volume of the stock you are considering.
(Chapter VII)
... "Remember that stocks are never too high for you to
begin buying or too low to begin selling. But after the initial
transaction, don't make a second unless the first shows you a
profit. Wait and watch."
As he prepares to close this
chapter on how to deploy new stock positions, Jesse Livermore
reiterates the importance of buying with the primary trend and
beginning new deployments small. Since trends can run a long
time, he wisely points out that absolute stock prices are really
irrelevant for buying and selling decisions for speculators.
All that matters for speculators
is today's temporal position within the prevailing trend. If
the trend has time to run yet then today's prices really don't
matter. If you buy today on a bull trend that is not yet finished,
odds are that your stocks will head to even higher prices before
the trend reverses. Similarly if you short sell an already battered
stock when a general bear trend hasn't yet ended, then you will
probably still earn a profit. The key is carefully watching the
market conditions and keeping the pulse of the primary trend
with which you are betting.
But, since we cannot know for
certain how long a trend has left to run before it ends, it is
wise to gradually scale in positions as Jesse Livermore taught.
Start out by only deploying a fraction of your desired capital
in your target bet. If you are right, and the profits come, then
you can scale in more as time marches on. But if you are wrong
and the markets move against you, the prudent use of scaling
shields you from large losses and keeps your precious capital
protected until a more opportune time.
(Chapter VII)
... "Suppose a man's line is five hundred shares of stock.
I say that he ought not to buy it all at once; not if he is speculating.
If he is merely gambling the only advice I have to give him is,
don't! Suppose he buys his first hundred, and that promptly shows
him a loss. Why should he go to work and get more stock? He ought
to see at once that he is in wrong, at least temporarily."
Here Jesse Livermore further
fleshes out the all-important distinctions between intelligent
speculation and flat-out Vegas-style gambling.
A speculator will gradually layer in positions, immediately stopping
if the markets prove him wrong over the short-term. Yes, he may
be right in the near future, but why absorb a big loss if he
happens to be early? Why not preserve capital for a better opportunity
in the weeks ahead?
Gamblers, on the other hand,
will bet it all on one roll of the dice. They will get excited,
grow convinced of a sure thing, and they will drop their entire
war chest of speculative capital on the table at one time. The
problem with this approach is that no one wins all the time,
and by betting everything every time sooner or later a speculator
will get crushed by some massive loss.
Part of the education of a
speculator involves learning how to merely survive, to ensure
that no single bets are ever so large that a major loss will
wipe out the speculator. Speculators, like any other profession,
grow better through time, experience, and practice. Using Livermore's
scaling, a speculator can protect himself from deploying bets
that are too large at the wrong time and losing so much capital
that he simply cannot afford to speculate anymore.
Preserving capital is crucial
to ensuring a speculator's survival and longevity. The longer
that you prudently manage your risk so that you can stay in the
game, the better you will become. If you lose it all on one big
bad bet, then you are out of the game until you can rebuild your
capital, a difficult task. Using intelligent strategies like
Livermore's scaling vastly increase speculators' ability to prudently
manage their own risks and keep themselves in this grand game.
Well, unfortunately this is
all of Jesse Livermore's wisdom that fits into this eighth essay
of my series on "Reminiscences." I hope you found Mr.
Livermore's great wisdom enlightening!
Go buy and read "Reminiscences
of a Stock Operator" today! I can almost guarantee that
it will forever change your life as a speculator! Jesse Livermore's
quotes are even more impressive in their proper context and are
delightful to read and digest. This essay format can't even start
to do them justice.
Until next time, Godspeed and
happy speculating!
May 14, 2004
Adam Hamilton, CPA
email:
zelotes@zealllc.com
Archives
The Series:
Wisdom
of Jesse Livermore 8 5.14.2004
Wisdom
of Jesse Livermore 7 1.2.2004
Wisdom
of Jesse Livermore 6 10.31.2003
Wisdom
of Jesse Livermore 5 8.29.2003
Wisdom
of Jesse Livermore 4 7.3.2003
Wisdom
of Jesse Livermore 3 5.2.2003
Wisdom
of Jesse Livermore 2 2.28.2003
Wisdom
of Jesse Livermore 1 1.31.2003
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