20 August 2013
JESSE LIVERMORE MONEY MANAGEMENT RULES
Excerpted from book "Trade Like Jesse Livermore"
MONEY MANAGEMENT RULE 1:DON’T BUY YOUR ENTIRE POSITION ALL AT ONE TIME
He liked to call this his probe system. Don’t lose money, don’t lose your
stake, don’t lose your line. A speculator without cash is like a store owner
with no inventory. Cash is your inventory, your lifeline, your best friend—
without cash you’re out of business. Don’t lose your damn line!
Livermore felt that it is wrong and dangerous to establish your full
stock position at only one price. Rather, 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 this way:
Start with a 200-share purchase on the Pivotal Point—if the price goes
up, buy an additional 200 shares, still within the Pivotal 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.
It is very important to note that each additional purchase must be
made at a higher price. The same rules, of course, would apply to selling
short, only each short sale would be at a lower price than the preceding
one.
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 judgement is correct in the trade.
The stock is going in the right direction—and that is all the proof you
need. Conversely, if you lose money, then you know immediately that your
judgment was wrong.
The tough psychological part for the inexperienced speculator is to
pay more for each position. Why? Because everyone wants a bargain. It
goes against human nature to pay more for each trade. People want to buy
at the bottom and sell at the top.
The speculator may choose a different ratio for purchasing the stock
than Livermore’s ratio of 20 percent on the first purchase, 20 percent on the
second purchase, 20 percent on the third purchase, and a final purchase of
40 percent. He could, for instance, purchase 30 percent as the first probe position,
30 percent as the second and 40 percent for the final probe position.
In summary, it is up to each individual speculator to decide the ratio
that works best for him. Livermore simply outlined what worked best for
him. The main money management rule is comprised of three factors:
1. Do not take your entire position all at once.
2. Wait for confirmation of your judgment—pay more for each lot you buy—dollar average upward.
3. At the beginning of each trade first establish in your mind the total,
exact amount of shares you want to purchase if all goes well, or specify
the amount of dollars you are willing to commit; do this before you
begin the trade.
MONEY MANAGEMENT RULE 2: NEVER LOSE MORE THAN 10 PERCENT OF YOUR INVESTMENT
He called this his Bucket Shop rule because he learned it in the bucket
shops as a young man, when he worked all his trades with 10 percent margin.
In the bucket shops, if the price of the stock went down below your
margin requirements you were automatically sold out. If the loss exceeded
the 10 percent limit, you were sold out and lost your bet. The 10
percent loss rule became Livermore’s most important rule for managing
money. In some respects, it is also a key timing rule, since it often automatically
sets the time to exit a trade—when you have lost 10 percent or
more of your invested capital, you must exit the trade. Also, a trader must
set a firm stop before opening a trade. The consequences of big losses are
drastic—you must gain back 100 percent to cover a loss of 50 percent.
TABLE 5.1 Livermore Percentage Loss Table
Starting Position Amount Lost Remainder %Loss %to Recover Loss
$1000 $ 80 $920 8.0 8.7
100 900 10.0 11.1
200 800 20.0 25.0
300 700 30.0 42.8
400 600 40.0 66.6
500 500 50.0 100.0
Also understand that when your broker calls and tells you he needs
more money for a margin requirement on a stock that is declining, always
tell him to sell out your position. When you buy a stock at 50 and it goes to
45, do not buy more in order to average out your price. The stock has not
done what you predicted; that is enough of an indication that your judgment
was faulty! Take your losses quickly and get out.
Remember, never meet a margin call, and never average losses.
Many times Livermore would close out a position before suffering a
10% loss. He did this simply because the stock was not acting right from
the start. He told friends that often his instincts would whisper to him,
“ ‘J.L., this stock has a malaise, it is a lagging dullard or just does not feel
right,’and I would sell out my position in the beat of a bird’s wing.”
Perhaps this was the inner mind working, distilling numerical patterns
and formations that he had seen thousands of times before, and
sending subconscious signals to his brain, unconsciously registering repeating
patterns to be stored in his memory bank. Perhaps these patterns
were subliminally remembered and awakened when recognized. Whatever
it was, he learned over the years, through many of his market experiences,
to respect these instincts.
He had observed countless 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 in the hope that it
will rally eventually and climb back up. This is why the 10% rule is essential.
Livermore’s advice: Don’t ever become an involuntary investor. Take
your losses quickly! Easy to say, hard to do.
If he bought a stock with a certain scenario in mind for what he
expected the stock to do and it did not follow through with the expected
scenario and go up immediately, he often just went ahead and
dumped it, sold it automatically. He also never looked back—he had
no self-recriminations after a bad trade or bitter thoughts if the stock
later took off. He did, however, often study the trade to see what he had
done wrong.
MONEY MANAGEMENT RULE 3: ALWAYS KEEP A CASH RESERVE
The successful speculator must always have cash in reserve, like a good
general who keeps troops in reserve for exactly the right moment, when
the odds are in his favor, and then moves with great conviction, and commits
his reserve armies for the final crushing victory.
There is a never-ending stream of opportunities in the stock market. If
you miss a good opportunity, wait a little while, be patient, and another
one will come along.
Livermore used the analogy of playing cards—for him it was highstakes
poker and bridge. He believed it was only human nature to want to
play every hand. This desire to always be in the game, is a common flaw
and one of the speculator’s greatest enemies in managing his money. It
will eventually bring about disaster, as it had brought bankruptcy and financial
disaster to Livermore several times in his early career. The observation
made below is a critical factor in understanding the Livermore
trading system.
There are times when playing the stock market that your money
should be inactive, waiting on the sidelines in cash to come into play in
the stock market. It was Livermore’s belief that in the stock market:
Time is not money
Time is time
And money is 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 trader’s best
friend if he uses it right.
MONEY MANAGEMENT RULE 4: YOU NEED A GOOD REASON TO BUY A STOCK AND YOU NEED A GOOD REASON TO SELL
Stick with the winners—as long as the stock is acting right, do not be in
a hurry to take a profit. You must know you are right in your basic judgment,
or you would have no profit at all. If there is nothing basically
negative, well then, let it ride! It may grow into a very large profit. As
long as the action of the overall market and the stock does not give you
cause to worry, let it ride—have the courage of your convictions. Stay
with it!
When you are in profit on a trade, you never need to be nervous. Livermore
could have a line of a hundred thousand shares out on a single
stock play and sleep like a baby. Why? Because he was in profit on that
trade. He was simply using the track’s money—the stock market’s money.
His attitude was that if he lost all his profit—well then he had lost money
he never had in the first place, since he did not count the money as profit
until he sold the stock and converted it to cash.
Profits Take Care of Themselves—Losses Never Do
Never confuse this approach of letting the position ride with the “buy
and hold forever” strategy. How can any trader know what will occur
far into the future? Things change: Life changes, relationships change,
health changes, seasons change, your children change, your lover
changes, why shouldn’t the basic conditions that originally caused you
to buy a stock change? To buy and hold blindly on the basis that it is a
great company, or a strong industry, or that the economy’s generally
healthy was to Livermore the equivalent of stock-market suicide. He
said: “There are no good stocks—there are only stocks that make
you money.”
As already discussed, one of the most important points in buying a
stock was to try and buy as closely as possible to the Pivotal Point or the
Continuation Pivotal Point. It was from this point that the key decisions
are made. If the stock advanced from the Pivotal Points, you can hold it
and relax, because from then on you are playing with the house’s money,
not your own capital. If the stock pulls away from the Pivotal Point in the
opposite direction of the purchase, the experienced trader knows to automatically
sell his position. It therefore becomes the trader’s biggest job to
find the Reversal Pivotal Points and Continuation Pivotal Points. This is
the constant money management rule you must never break:
cut your losses, let your profits run.
Stick with the winners—let them ride until you have a clear reason
to sell.
MONEY MANAGEMENT RULE 5: PUT HALF THE PROFIT FROM A WINDFALL TRADE IN THE BANK
Livermore recommended parking 50 percent of your profits from a successful
trade, especially where you doubled your original capital. Set
this money aside, take it out of the stock market so you have to make a
conscious effort to put it back in. Put it in the bank, hold it in reserve,
lock it up in a safe deposit box, stuff it in your mattress—just put it
somewhere safe. Like winning in the casino, it’s a good idea, now and
then, to take your winnings off the table, and turn them into cash. There
is no better time then after a large win on a stock. Cash is your secret
bullet in the chamber.
The single largest regret I have ever had in my financial life
was not paying enough attention to this rule.
—Jesse Livermore
Here is a summary of Jesse Livermore’s money management rules:
1. Use probes—don’t buy your entire position all at one time;
2. Never lose more than 10 percent of your investment;
3. Always keep a cash reserve;
4. You need a reason to buy a stock and you need a reason to sell;
5. Put half the profit from a windfall trade in the bank.
ADDITIONAL ADVICE
Stay Away from Cheap Stocks
One of the greatest mistakes that even experienced investors make is buying
cheap securities just because they are selling at a low price. Although
in some instances stock demand may push the stock from a small per share
price of say, $5 or $10 a share to over $100, many of these low-priced
stocks later sink into oblivion by going into receivership, or else they
struggle for years and years, with only the slightest prospect of ever returning
a profit to their shareholders.
In selecting securities, it is essential for an investor to determine
which industries or groups are in the strongest position, which are less
strong, and which groups are comparatively weak, very weak, etc. The
speculator should not plunge into cheap stocks in depressed industry
groups just because the stock may appear to be a bargain. Stay with the
powerful, healthy Industry Groups.
Keep Your Funds Liquid and Working for You
Perhaps nothing has contributed to the traditional poor success of the
public in the investment markets as much as this fact—the average market
investor does not keep his investment and speculative funds in proper
circulation. The public is usually in a permanent loaded-up or tied-up condition,
buried in a stock or a number of stocks with no cash or buying
power held in reserve.
If the public observes a certain stock that may advance a few points a
month, are they interested? No, they want something that moves more
quickly. Yet in a few months they will probably wake up to see the stocks
they refused to buy now selling for 20 points higher, while their cheap,
volatile stocks, which they actually purchased, are selling at less than the
prices they paid for them.
Disregard the Action of Insiders
Never pay any attention to the actions of insiders—this includes company
directors and management. Insiders are commonly the absolute worst
judges of their own stock. They usually know too much about their
stocks, and they are too close to observe the weaknesses. Key executives
also are usually ignorant about the stock market, especially market technical
indicators and group movement. They are often reluctant to admit
that the stock market is a specialty business and is an entirely different
business from their own. In other words, you can be an expert in radio
broadcasting or selling automobiles, or the manufacture of steel or pharmaceuticals,
and most likely not know anything about trading stocks, especially
in a volatile stock market as we had in the late 1990s and early in
the new millennium.
Disregard Any Statement Made by Key Executives
The chief executive officer of most companies is little more than a cheerleader
who has only one job with regard to the market. He must assure
and reassure the shareholders, including the mutual funds and potential
future shareholders, that everything is fine—if sales are down, he tells the
shareholders that the decline is nothing more than a slight problem due to
some temporary reason like seasonality, terrorism or competitors’ lowering
their prices. If profits are down, he assures the shareholders there is
nothing to worry about, since the company has already reacted and made
adequate plans to recapture their profitability.
Before Buying a Stock Establish Profit Target—Risk/Reward Ratio
The intelligent trader pays a lot of attention to the ratio of potential profit
and the size of his overall investment. If a stock was trading at $200 and
you are expecting a 20-point move or 10%, then you know you will have to
put up $200,000 to make $20,000. This was not appealing for Livermore,
because for him the risk/reward ratio was out of balance. No matter how
good a trader you are, stock market losses are inevitable and must be considered
as part of a trader’s operating expenses, along with interest, brokerage
fees, and capital gains tax. Few stock traders establish a
risk/reward ratio before they enter a trade. It is essential to try to do this
in order to have a specific money management plan.
Livermore was a lot less active in his trading than people thought. In
fact, in his later life he was only interested in the “essential move,” the important
swing in the stock price. This often took extra patience in waiting
for all the factors to come together to a focal point, where he felt as much
as possible that everything was in his favor: the direction of the overall
market, the industry group, the sister stock activity and, finally, an important
Pivotal Point.
A famous misunderstood quote of Livermore was: “It was the sittin’
and the waitin’ that made me the money.”
He did not mean the sitting and waiting after the stock was purchased—
he meant before he pulled the trigger—that’s when the trader
must have the patience to sit and wait for all factors to come together to
merge into the perfect trade, or as perfect as possible.
Remember, it is very difficult to work your way back from a devastating
loss—this is true no matter what anyone tells you. Don’t wind up without
cash, like the merchant with no inventory—that’s the same as a stock
trader with no cash—out of business.
Always Establish a Stop before Making a Trade
When you purchase a stock, you should always have a clear price target of
where to sell if the stock moves against you. And you must obey your
rules! Never sustain a loss of more than 10% of your invested capital.
Losses are twice as expensive to make up, as previously explained. This
point can not be made often enough.
Always establish your stop before making the trade. This is another
reason for buying on the Pivotal Point—it always gives the trader a clear
point of reference. The Pivotal Point acts as a place to establish the stop
loss point—the spot for the trader to close out the trade if things go
against him.
Before making a trade, most stock traders do not take the time to observe
the following rules:
• Decide on the potential of the trade versus the size of the investment—
if it is a large investment with a small potential return, then
pass. The trader should see a clear profit potential.
• Before you buy, make sure that you are buying at a crucial Pivotal
Point, and use this as the spot to establish your exit point—your stop
loss point if the trade goes bad. Write this number down and honor
it—cut your losses—this is the most important thing for the trader to
know, even if you get whipsawed and it rallies right back. It did not do
what you expected it to do at the time you pulled the trigger–this is
the most important thing to remember.
• Make sure all things are in your favor, market direction, group direction,
sister stock direction and the exact timing is in place.
• At this point, the trader must then assume the status of an automaton,
a robot, and he must then follow his rules.
Remember that no trader’s judgement is infallible; if it were always
correct, that person would soon be the richest on this planet. But it is not
the case—we all make mistakes, and we will continue to make mistakes
in our lives and in the stock market! The rewards can be enormous if we
can learn to “cut the losses quickly and let the profits ride.”
Points Are a Key to Money Management
Livermore wanted at least the opportunity of a 10 point gain in any stock
he invested in.
Potential profit points were key in his trading. He was well aware that
if a stock goes from $10 to $20 it is a 100 percent gain, whereas a stock
that goes from $100 to $200 is a hundred point gain, as well as a hundred
percent increase in value.
He always bought in round lots and used his probing technique to buy:
1. An initial position of 20 percent,
2. A second position of 20 percent,
3. A third at position of 20 percent, and
4. A final purchase of 40 percent, with all purchases being at a higher
price and therefore higher cost.
This proved to him that the stock was moving in the direction he wanted
it to.
As previously explained, the main challenge for the trader is to identify
the current market leaders and to spot the new market leaders who
are waiting to take over from the current ones. During major shifts and
changes in market direction, it is of paramount importance for the trader
to observe the leaders that are being driven out and identify the new
stocks that will assume leadership in the future.
It is usually always best to go with the strongest stock in the strongest
group—do not look for the cheapest or the laggard stock that has not yet
had his turn to move in the group—always go for the strongest most dominant
stock in the group.
Livermore’s Method of Pyramiding
The trader must learn: You never average down.
That is, if the stock you bought goes down in price—do not buy any
more and try to average your price—it hardly ever works. But what
does often work is “averaging up” in price—buying more as the stock
goes up in price. But this can be dangerous also, so try to establish your
main position at the beginning, at the initial Pivotal Point, and then increase
it at the Continuation Pivotal Point—providing the stock comes
out of the consolidation with strength. The trader must wait until the
stock has proven it is going to break out on the strong side of the Continuation
Pivotal Point; until the stock declares itself, it is always a risk. At
these junctures the trader must watch like a hawk and stay poised, but
not biased by hope.
The final time a trader can pyramid is when a stock breaks out to a
clear new high, especially if it moves on heavy volume (see Figure 5.1);
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.
All pyramiding in the stock market is a dangerous activity, and anyone
who tries it must be very agile and experienced, for the further a stock
moves in its rise or decline the more dangerous the situation becomes.
To offset the risk, Livermore tried to restrict any serious pyramiding to the
beginning of the move. He found it unwise to enter a pyramiding action if
the stock was far from the Pivotal Point base—better to wait for the next
Continuation Pivotal Point or the break-out to a new high.
The trader must always remember there are no ironclad rules to the
stock market, the main objective for the stock speculator is to try and
place as many factors in his favor as he can. And even with these in place,
the trader will still be wrong on many occasions, and he must react by cutting
his losses.
Here is a money management rule that cannot be stated often enough:
A trader should always keep some cash in reserve for those incredible
moments in trading the market when all the factors come together to form
the “Supreme Trade at the Perfect Moment” such as occur at the zenith of
bull markets and the nadir of panics. Many of these trading moments have
recently occurred in 2003, and more still remain for 2004. There is no better
feeling than having a strong army of cash standing by, waiting for your
command to move into action.
Profits: The Spine of Every Stock
There is no magic about achieving success in the stock market. The only
way for anyone to succeed in investments is to investigate before investing;
to look before he leaps; to stick to the fundamentals of his own personal
list of rules, and disregard everything else. But, of course, first he
must establish his list of trading rules. Jesse Livermore was one of the
most successful traders in history. In this section, the trader is getting a
look at his money management rules.
Livermore would say to today’s trader: “Take my rules and try them. I
established them after having made many mistakes and thousands of
hours of analysis and they work. If I can save you the pain and expense I
endured, I will be happy to have done so.”
Every trader must also understand that, in the end, in the final
analysis, when the dust settles on a stock, it is the earnings—profits,
and profit potential—that actually establish the final price of the stock.
This happens when the emotions are wrung out and reality finally does
settle in. But the trader must also understand that it is always hope and
greed that grease the skids, lubricate the wheels of volatility on the
stock’s journey. The promise of superior earnings may have driven the
stock in its history. But in the final analysis, it is real profits and real results
that eventually cause the price of stocks to settle. Reality will always
eventually set in to produce a final conclusion for the industry
group and any particular stock. This will be revealed to the skilled technical
trader as it occurs.
Don’t Give Your Money to Others to Trade
It has become apparent in today’s modern scandal-ridden markets that
there is no security or safety in trading in the shares of large blue-chip
companies or listening to highly accredited analysts, or trusting old, steadfast
mutual funds. Where big money is concerned, there is always the danger
of illegal activities lurking in the background. And there is no more
money at stake than in the American stock markets.
The gangsters, the con men, the thieves, the swindlers, the grifters, all
know where the money is and are always thinking of ways to help themselves
to the stock trader’s money. This comes as an additional burden in
the field of stock trading, which is a most difficult field to begin with—a
place where only the skillful, disciplined trader has a chance.
Here is one of Livermore’s famous sayings: “If I am going to lose my
money in the stock market, as so many people do . . . then I would prefer
to lose it myself. I do not need a broker to lose it for me.”
When you are handling surplus income, do not delegate the task to
anyone. Whether you are dealing in millions or in thousands, the same
principal lesson applies. It is your money. It will remain with you just so
long as you guard it. Faulty speculation is one of the most certain ways of
losing it.
Blunders by incompetent speculators and traders cover a wide scale.
Livermore warns strongly against averaging losses. That is a most common
practice. Great numbers of people will buy a stock, let us say at 50,
and 2 or 3 days later if they can buy it at 47 they are seized with the urge to
average down by buying another hundred shares, making an average price
of 48 on all.
Having bought at 50 and being concerned over a three-point loss on a
hundred shares, what rhyme or reason is there in adding another hundred
shares and having the double worry when the price hits 44? At that point,
there would be a $600 loss on the first hundred shares and a $300 loss on
the second hundred shares.
If one is to apply such an unsound principle, he should keep on averaging
by buying 200 shares at 44, then 400 at 41, 800 at 38, 1600 at 35,
3200 at 32, 6400 at 29, and so on. How many speculators could stand
such pressure? Yet if the policy is sound, it should not be abandoned. Of
course, abnormal moves such as the one indicated do not happen often.
But it is just such abnormal moves against which the speculator must
guard to avoid disaster.
So, at the risk of repetition and preaching, avoid averaging down. Livermore
received one sure tip from a broker concerning a margin call:
When the margin call reaches you, close your trade—never meet a margin
call. This proves you are on the wrong side of the market. Why send good
money after bad? Keep that good money for another day. Risk it on something
more attractive than an obviously losing deal.
A successful businessman extends credit to various customers, but
typically would not sell his entire output to one customer. The larger the
number of customers, the more widely the risk is spread. Just so, a person
engaged in the business of speculation should risk only a limited amount
of capital on any one venture. As stated, cash to the speculator is like merchandise
on the shelves of the merchant.
One major mistake of all speculators is the urge to enrich themselves
in too short a time. Instead of taking 2 or 3 years to make 500 percent on
their capital, they try to do it in 2 or 3 months. Now and then they succeed.
But do such daring traders keep it?
They do not. Why? They do not take some money off the table from
time to time.
This one rule haunted Livermore because he did not always adhere to
it. In fact, he consistently broke it. When he made a large profit in a trade,
he did not take some of the profit off the table, out of the market and put it
in the bank. It was one of the major regrets of his trading years.
Most people do not think they earned the money they make in the
market because all they have done is make a phone call and shuffle some
paper. There is no actual work involved in trading, no service being offered
such as a doctor, mechanic, carpenter, plumber provides, nothing
being manufactured like a lawn mower, a car, a suit of clothes. As a result,
a lot of people have trouble psychologically, it appears to them as unhealthy
money, rolling in rapidly, and stopping for but a short visit. The
speculator in such instances loses his sense of balance. The uninitiated
public investor says: “If I can make 500 percent on my capital in 2 months,
think what I will do in the next 2! I will make a fortune with basically no
work. I call, place my order with the broker, and collect my profits—it’s no
wonder rich people play the stock market.”
Such speculators are never satisfied. They continue to shoot the
works until somewhere a cog slips, something happens—something drastic,
unforeseen, and devastating. At length comes that final margin call
from the broker, the call that cannot be met, and this type of plunger goes
out like a lamp. He may plead with the broker for a little more time, or if
he is not too unfortunate, he may have saved a nest egg permitting a modest
new start.
Businessmen opening a shop or a store would not expect to make
over 25 percent on their investment the first year. But to people who enter
the speculative field 25 percent is nothing. They are looking for 100 percent.
And their calculations are faulty; they fail to make trading a business
and run it on business principles. In the end, Livermore believed that 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 trade.
Livermore used to tell this story to his friends:
“I recall one day in Palm Beach. I left New York with a fairly large
short position open. A few days after my arrival in Palm Beach the market
had a severe break. That was an opportunity to cash paper profits into real
money—and I did.
“After the market closed I gave a message to the telegraph operator to
tell the New York office to send immediately to my bank one million dollars
to be deposited to my credit. The telegraph operator almost passed
out. After sending the message, he asked if he might keep that slip. I inquired
why.
“He said: I’ve been an operator here in Palm Beach for twenty years
and that was the first message I ever sent asking a broker to deposit in a
bank money for the account of a customer.
“He went on: I’ve seen thousands and thousands of messages passing
over the wire from brokers demanding margins from customers. But
never before one like yours. I want to show it to the boys.”
The only time the average trader can draw money from his brokerage
account is when he has no position open or when he has an excessive equity.
He won’t draw it out when the markets are going against him because
he needs all his capital for margin.
He won’t draw it out after closing a successful deal because he says to
himself: “Next time I’ll make twice as much.”
Consequently most speculators rarely see the money. To them, the
money is nothing real, nothing tangible. For years, after a successful deal
was closed, Livermore made it a habit to draw out cash. He would draw it
out of the market at the rate of $200,000 or $300,000 a clip. It had a psychological
value for Livermore. He made it a policy to count the money
over again. It was then that he knew he had something in his hand. He felt
it. He spent a little. He knew his hard work was producing real money.
For Livermore, money in a broker’s account or in a bank account was
not the same as if you felt it in your own fingers once in a while. Then it
meant something. There is a sense of possession that makes you just a little
bit less inclined to take headstrong chances of losing your gains. So
every trader should have a look at his real money once in a while, particularly
between market deals.
Livermore was unable to make any money outside of Wall Street. In
fact, he lost many millions of dollars, which he took from Wall Street and
invested in other ventures, such as real estate in the Florida boom, oil
wells, airplane manufacturing, and the perfecting and marketing of products
based on new inventions. He always lost every cent.
In one of these outside ventures that had whipped up his enthusiasm,
he sought to interest a friend of his in investing $50,000. His friend listened
to his story very attentively. When Livermore finished, the friend
said: “Livermore, you will never make a success in any business outside of
your own. Now if you want $50,000 with which to speculate it is yours for
the asking. But please trade stocks and stay away from business.” The
next morning, to his surprise, the mail brought a check for that amount,
which Livermore did not need and sent back.
The lesson here again is that trading stocks is itself a specialty business
like any other, and should be so viewed by all who wish to trade in
the market. Do not permit yourself to be influenced by excitement, flattery,
or temptation. Keep in mind that brokers sometimes innocently
become the undoing of many traders. Brokers are in the business to
make commissions. They cannot make commissions unless customers
trade. The more trading, the more commissions. The speculator wants
to trade, and the broker not only is willing, but too often encourages
over trading. The uninformed trader regards the broker as his friend and
is soon over trading.
Now if the speculator were smart enough to know at just which time
he should over trade, the practice would be justified. He may know of
times when he could or should over trade. But once acquiring the habit,
very few traders are smart enough to stop. They are easily carried away
emotionally, and they lose that peculiar sense of balance so essential to
success. They never think of the day when they will be wrong. But that
day always arrives. The easy money they might have made takes wing, and
another trader goes broke.
Follow the rules—never make any trade unless you know you can do
so with financial safety.
POSTSCRIPT
Many legends about Jesse Livermore have persisted over the years. In my
research on Livermore, the following story was told to me by Patricia Livermore,
his daughter-in-law, married to Jesse Jr., and then again by Paul
Livermore, Jesse’s younger son. I have written it down faithfully as it was
told to me.
Livermore’s Annual New Year’s Ritual
“Good afternoon, Mr. Livermore.”
“Hello, Alfred.”
It was the Friday before the New Year of 1923. Livermore walked into
the Chase Manhattan Bank, late in the afternoon. He was warmly greeted
by Alfred Pierce, the bank manager. Livermore was one of the bank’s best
customers, keeping a balance of at least two million dollars in reserve for
his special “stock situations,” when he needed extra cash to establish one
of his famous stock purchases or perhaps engage in a raid or activate a
commodity corner.
“We have everything ready for you, J.L.,” Alfred said. (People who
knew Livermore well called him J.L.)
Livermore looked at his watch—it was almost 5:15. The bank was already
closed. They had let him enter the bank through the employees’
door. “Yes, J.L., the closing bank vault time-lock is set for 5:30, as always.”
They walked in silence across the great vaulted room of the main
branch through the door that separated the tellers’ cages from the public
and entered the back of the bank.
“And Monday morning?” Livermore asked.
“Monday, the timer on the vault is set to open at 8:00 sharp, like
always.”
“I just like to be sure.” Livermore added with a smile.
“I understand, J.L.—by that time you will have had enough solitude.”
“Yes Alfred, of that I am sure.” Livermore said. He was carrying a
leather briefcase. Alfred looked at the briefcase. “Do you mind me asking
what’s in the briefcase?”
“Not at all. It is my entire trading history for 1923. I will review every
trade I made and refer to my notes. I keep good notes on all my trades that
explain why I bought or went short and why I closed my positions.”
“So you don’t win every time?” Alfred said facetiously.
“Alfred, there are many rumors about me; of course, you know that I
lose. I am only human. The idea is to get out fast when a trade goes
against you. I often lose, that is what I am trying to figure out this weekend—
why did I lose on certain trades over the year.”
They approached the main vault. It was huge with a giant solid steel
door. Two armed security men stood on either side of the door. They nodded
at Alfred and Jesse Livermore. They knew what was going on.
The two men crossed over the threshold and entered the cavernous
vault. There was a large amount of cash in a series of open chests. Most of
the bills were hundreds with one chest full of twenties and fifties. There
was a desk, a chair, a cot, and an easy chair in the middle of the cash.
There was a special light above the desk and a second light above the easy
chair. Livermore went over to the cash in the open chests and looked
down at the uncovered bills. “There is almost fifty million here. The exact
amount is written on the pad on your desk. The last of it came over from
E. F. Hutton’s this afternoon.”
Jesse Livermore had sold out almost every position he had in both
stocks and commodities, as he did at the beginning of every new year. He
stared down at the cash.
“I would like to have the commission on just these sales, J.L.,” Alfred
said.
“This is not all of it. In some cases the market was too thin to take the
hit, so that stock will be sold slowly over the next few weeks or so, and
will be sent here for safekeeping.”
“When will you resume trading?”
“Most likely in February, after I get to Palm Beach.”
The red light on the ceiling started to flash and a low-level bell rang at
20-second intervals. The bank manager looked at his watch.
“Five minutes before the vault closes, J.L. The food is over here.”
The bank manager went to an icebox in the corner. “We got everything
that your office manager Harry Dache ordered for you. He actually
brought the food over himself about an hour ago, and we had an ice delivery
around noon. Bread, cold cuts, vegetables, water, milk, juices and
the makings for some old fashioneds.” Alfred pointed into the open icebox
door.
“Thanks, those old fashioneds will come in handy.”
“Right you are, J.L. I’m going to leave now, I suffer from claustrophobia
and all this money scares me.”
Livermore walked the bank manager to the vault door. They shook
hands. “J.L. if anyone ever knew about this . . . well . . . they might think
that you were eccentric.”
“Eccentric is a kind word, Alfred.” Jesse Livermore smiled as the
door started to swing shut, pushed by the two armed guards. “You see, Alfred,
all year long all I see is and endless stream of paper. This weekend
makes it real for me . . . real cash—nothing like it.
Livermore stood at the door as it clanged shut. The lights above the
desk and the easy chair now provided an eerie but adequate light. Livermore
surmised that no one had ever actually tested them with the door
shut; no one would volunteer to be locked inside the vault.
He turned and walked to the desk surrounded by almost fifty million
dollars in cash. For the next two days and three nights this would be his
home. Inside the cavernous vault he would retreat into deep solitude and
review his entire trading year from every aspect . . . just as he had done
every year since he had started trading.
When it was time to leave on Monday morning he would go to the
chest that held the twenties and the fifties and stuff his pockets with
as much cash as he desired, and over the next two weeks he would
spend it.
He had not locked himself up with his cash as a miser might lock himself
up to count his money in the counting house. No, Livermore, because
his world was a world of paper transactions all year long, believed that by
the end of the year he had lost his perception of what the paper slips really
represented—cash money, and ultimately, power.
By the end of the year, he was just shuffling paper. Livermore
needed to touch the money and feel the power of cash. It also made him
reappraise his stock and commodity positions and determine: Were
these positions he would keep if he had the choice—were there better opportunities?
Selling everything out forced him to appraise whether or not
he would buy these positions back.
When he walked out of the vault on the Monday morning with pockets
full of cash, he would start his shopping spree, a spree that usually lasted
for at least a week and included spending on many human pleasures as
well as material items.
MONEY MANAGEMENT RULE 1:DON’T BUY YOUR ENTIRE POSITION ALL AT ONE TIME
He liked to call this his probe system. Don’t lose money, don’t lose your
stake, don’t lose your line. A speculator without cash is like a store owner
with no inventory. Cash is your inventory, your lifeline, your best friend—
without cash you’re out of business. Don’t lose your damn line!
Livermore felt that it is wrong and dangerous to establish your full
stock position at only one price. Rather, 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 this way:
Start with a 200-share purchase on the Pivotal Point—if the price goes
up, buy an additional 200 shares, still within the Pivotal 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.
It is very important to note that each additional purchase must be
made at a higher price. The same rules, of course, would apply to selling
short, only each short sale would be at a lower price than the preceding
one.
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 judgement is correct in the trade.
The stock is going in the right direction—and that is all the proof you
need. Conversely, if you lose money, then you know immediately that your
judgment was wrong.
The tough psychological part for the inexperienced speculator is to
pay more for each position. Why? Because everyone wants a bargain. It
goes against human nature to pay more for each trade. People want to buy
at the bottom and sell at the top.
The speculator may choose a different ratio for purchasing the stock
than Livermore’s ratio of 20 percent on the first purchase, 20 percent on the
second purchase, 20 percent on the third purchase, and a final purchase of
40 percent. He could, for instance, purchase 30 percent as the first probe position,
30 percent as the second and 40 percent for the final probe position.
In summary, it is up to each individual speculator to decide the ratio
that works best for him. Livermore simply outlined what worked best for
him. The main money management rule is comprised of three factors:
1. Do not take your entire position all at once.
2. Wait for confirmation of your judgment—pay more for each lot you buy—dollar average upward.
3. At the beginning of each trade first establish in your mind the total,
exact amount of shares you want to purchase if all goes well, or specify
the amount of dollars you are willing to commit; do this before you
begin the trade.
MONEY MANAGEMENT RULE 2: NEVER LOSE MORE THAN 10 PERCENT OF YOUR INVESTMENT
He called this his Bucket Shop rule because he learned it in the bucket
shops as a young man, when he worked all his trades with 10 percent margin.
In the bucket shops, if the price of the stock went down below your
margin requirements you were automatically sold out. If the loss exceeded
the 10 percent limit, you were sold out and lost your bet. The 10
percent loss rule became Livermore’s most important rule for managing
money. In some respects, it is also a key timing rule, since it often automatically
sets the time to exit a trade—when you have lost 10 percent or
more of your invested capital, you must exit the trade. Also, a trader must
set a firm stop before opening a trade. The consequences of big losses are
drastic—you must gain back 100 percent to cover a loss of 50 percent.
TABLE 5.1 Livermore Percentage Loss Table
Starting Position Amount Lost Remainder %Loss %to Recover Loss
$1000 $ 80 $920 8.0 8.7
100 900 10.0 11.1
200 800 20.0 25.0
300 700 30.0 42.8
400 600 40.0 66.6
500 500 50.0 100.0
Also understand that when your broker calls and tells you he needs
more money for a margin requirement on a stock that is declining, always
tell him to sell out your position. When you buy a stock at 50 and it goes to
45, do not buy more in order to average out your price. The stock has not
done what you predicted; that is enough of an indication that your judgment
was faulty! Take your losses quickly and get out.
Remember, never meet a margin call, and never average losses.
Many times Livermore would close out a position before suffering a
10% loss. He did this simply because the stock was not acting right from
the start. He told friends that often his instincts would whisper to him,
“ ‘J.L., this stock has a malaise, it is a lagging dullard or just does not feel
right,’and I would sell out my position in the beat of a bird’s wing.”
Perhaps this was the inner mind working, distilling numerical patterns
and formations that he had seen thousands of times before, and
sending subconscious signals to his brain, unconsciously registering repeating
patterns to be stored in his memory bank. Perhaps these patterns
were subliminally remembered and awakened when recognized. Whatever
it was, he learned over the years, through many of his market experiences,
to respect these instincts.
He had observed countless 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 in the hope that it
will rally eventually and climb back up. This is why the 10% rule is essential.
Livermore’s advice: Don’t ever become an involuntary investor. Take
your losses quickly! Easy to say, hard to do.
If he bought a stock with a certain scenario in mind for what he
expected the stock to do and it did not follow through with the expected
scenario and go up immediately, he often just went ahead and
dumped it, sold it automatically. He also never looked back—he had
no self-recriminations after a bad trade or bitter thoughts if the stock
later took off. He did, however, often study the trade to see what he had
done wrong.
MONEY MANAGEMENT RULE 3: ALWAYS KEEP A CASH RESERVE
The successful speculator must always have cash in reserve, like a good
general who keeps troops in reserve for exactly the right moment, when
the odds are in his favor, and then moves with great conviction, and commits
his reserve armies for the final crushing victory.
There is a never-ending stream of opportunities in the stock market. If
you miss a good opportunity, wait a little while, be patient, and another
one will come along.
Livermore used the analogy of playing cards—for him it was highstakes
poker and bridge. He believed it was only human nature to want to
play every hand. This desire to always be in the game, is a common flaw
and one of the speculator’s greatest enemies in managing his money. It
will eventually bring about disaster, as it had brought bankruptcy and financial
disaster to Livermore several times in his early career. The observation
made below is a critical factor in understanding the Livermore
trading system.
There are times when playing the stock market that your money
should be inactive, waiting on the sidelines in cash to come into play in
the stock market. It was Livermore’s belief that in the stock market:
Time is not money
Time is time
And money is 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 trader’s best
friend if he uses it right.
MONEY MANAGEMENT RULE 4: YOU NEED A GOOD REASON TO BUY A STOCK AND YOU NEED A GOOD REASON TO SELL
Stick with the winners—as long as the stock is acting right, do not be in
a hurry to take a profit. You must know you are right in your basic judgment,
or you would have no profit at all. If there is nothing basically
negative, well then, let it ride! It may grow into a very large profit. As
long as the action of the overall market and the stock does not give you
cause to worry, let it ride—have the courage of your convictions. Stay
with it!
When you are in profit on a trade, you never need to be nervous. Livermore
could have a line of a hundred thousand shares out on a single
stock play and sleep like a baby. Why? Because he was in profit on that
trade. He was simply using the track’s money—the stock market’s money.
His attitude was that if he lost all his profit—well then he had lost money
he never had in the first place, since he did not count the money as profit
until he sold the stock and converted it to cash.
Profits Take Care of Themselves—Losses Never Do
Never confuse this approach of letting the position ride with the “buy
and hold forever” strategy. How can any trader know what will occur
far into the future? Things change: Life changes, relationships change,
health changes, seasons change, your children change, your lover
changes, why shouldn’t the basic conditions that originally caused you
to buy a stock change? To buy and hold blindly on the basis that it is a
great company, or a strong industry, or that the economy’s generally
healthy was to Livermore the equivalent of stock-market suicide. He
said: “There are no good stocks—there are only stocks that make
you money.”
As already discussed, one of the most important points in buying a
stock was to try and buy as closely as possible to the Pivotal Point or the
Continuation Pivotal Point. It was from this point that the key decisions
are made. If the stock advanced from the Pivotal Points, you can hold it
and relax, because from then on you are playing with the house’s money,
not your own capital. If the stock pulls away from the Pivotal Point in the
opposite direction of the purchase, the experienced trader knows to automatically
sell his position. It therefore becomes the trader’s biggest job to
find the Reversal Pivotal Points and Continuation Pivotal Points. This is
the constant money management rule you must never break:
cut your losses, let your profits run.
Stick with the winners—let them ride until you have a clear reason
to sell.
MONEY MANAGEMENT RULE 5: PUT HALF THE PROFIT FROM A WINDFALL TRADE IN THE BANK
Livermore recommended parking 50 percent of your profits from a successful
trade, especially where you doubled your original capital. Set
this money aside, take it out of the stock market so you have to make a
conscious effort to put it back in. Put it in the bank, hold it in reserve,
lock it up in a safe deposit box, stuff it in your mattress—just put it
somewhere safe. Like winning in the casino, it’s a good idea, now and
then, to take your winnings off the table, and turn them into cash. There
is no better time then after a large win on a stock. Cash is your secret
bullet in the chamber.
The single largest regret I have ever had in my financial life
was not paying enough attention to this rule.
—Jesse Livermore
Here is a summary of Jesse Livermore’s money management rules:
1. Use probes—don’t buy your entire position all at one time;
2. Never lose more than 10 percent of your investment;
3. Always keep a cash reserve;
4. You need a reason to buy a stock and you need a reason to sell;
5. Put half the profit from a windfall trade in the bank.
ADDITIONAL ADVICE
Stay Away from Cheap Stocks
One of the greatest mistakes that even experienced investors make is buying
cheap securities just because they are selling at a low price. Although
in some instances stock demand may push the stock from a small per share
price of say, $5 or $10 a share to over $100, many of these low-priced
stocks later sink into oblivion by going into receivership, or else they
struggle for years and years, with only the slightest prospect of ever returning
a profit to their shareholders.
In selecting securities, it is essential for an investor to determine
which industries or groups are in the strongest position, which are less
strong, and which groups are comparatively weak, very weak, etc. The
speculator should not plunge into cheap stocks in depressed industry
groups just because the stock may appear to be a bargain. Stay with the
powerful, healthy Industry Groups.
Keep Your Funds Liquid and Working for You
Perhaps nothing has contributed to the traditional poor success of the
public in the investment markets as much as this fact—the average market
investor does not keep his investment and speculative funds in proper
circulation. The public is usually in a permanent loaded-up or tied-up condition,
buried in a stock or a number of stocks with no cash or buying
power held in reserve.
If the public observes a certain stock that may advance a few points a
month, are they interested? No, they want something that moves more
quickly. Yet in a few months they will probably wake up to see the stocks
they refused to buy now selling for 20 points higher, while their cheap,
volatile stocks, which they actually purchased, are selling at less than the
prices they paid for them.
Disregard the Action of Insiders
Never pay any attention to the actions of insiders—this includes company
directors and management. Insiders are commonly the absolute worst
judges of their own stock. They usually know too much about their
stocks, and they are too close to observe the weaknesses. Key executives
also are usually ignorant about the stock market, especially market technical
indicators and group movement. They are often reluctant to admit
that the stock market is a specialty business and is an entirely different
business from their own. In other words, you can be an expert in radio
broadcasting or selling automobiles, or the manufacture of steel or pharmaceuticals,
and most likely not know anything about trading stocks, especially
in a volatile stock market as we had in the late 1990s and early in
the new millennium.
Disregard Any Statement Made by Key Executives
The chief executive officer of most companies is little more than a cheerleader
who has only one job with regard to the market. He must assure
and reassure the shareholders, including the mutual funds and potential
future shareholders, that everything is fine—if sales are down, he tells the
shareholders that the decline is nothing more than a slight problem due to
some temporary reason like seasonality, terrorism or competitors’ lowering
their prices. If profits are down, he assures the shareholders there is
nothing to worry about, since the company has already reacted and made
adequate plans to recapture their profitability.
Before Buying a Stock Establish Profit Target—Risk/Reward Ratio
The intelligent trader pays a lot of attention to the ratio of potential profit
and the size of his overall investment. If a stock was trading at $200 and
you are expecting a 20-point move or 10%, then you know you will have to
put up $200,000 to make $20,000. This was not appealing for Livermore,
because for him the risk/reward ratio was out of balance. No matter how
good a trader you are, stock market losses are inevitable and must be considered
as part of a trader’s operating expenses, along with interest, brokerage
fees, and capital gains tax. Few stock traders establish a
risk/reward ratio before they enter a trade. It is essential to try to do this
in order to have a specific money management plan.
Livermore was a lot less active in his trading than people thought. In
fact, in his later life he was only interested in the “essential move,” the important
swing in the stock price. This often took extra patience in waiting
for all the factors to come together to a focal point, where he felt as much
as possible that everything was in his favor: the direction of the overall
market, the industry group, the sister stock activity and, finally, an important
Pivotal Point.
A famous misunderstood quote of Livermore was: “It was the sittin’
and the waitin’ that made me the money.”
He did not mean the sitting and waiting after the stock was purchased—
he meant before he pulled the trigger—that’s when the trader
must have the patience to sit and wait for all factors to come together to
merge into the perfect trade, or as perfect as possible.
Remember, it is very difficult to work your way back from a devastating
loss—this is true no matter what anyone tells you. Don’t wind up without
cash, like the merchant with no inventory—that’s the same as a stock
trader with no cash—out of business.
Always Establish a Stop before Making a Trade
When you purchase a stock, you should always have a clear price target of
where to sell if the stock moves against you. And you must obey your
rules! Never sustain a loss of more than 10% of your invested capital.
Losses are twice as expensive to make up, as previously explained. This
point can not be made often enough.
Always establish your stop before making the trade. This is another
reason for buying on the Pivotal Point—it always gives the trader a clear
point of reference. The Pivotal Point acts as a place to establish the stop
loss point—the spot for the trader to close out the trade if things go
against him.
Before making a trade, most stock traders do not take the time to observe
the following rules:
• Decide on the potential of the trade versus the size of the investment—
if it is a large investment with a small potential return, then
pass. The trader should see a clear profit potential.
• Before you buy, make sure that you are buying at a crucial Pivotal
Point, and use this as the spot to establish your exit point—your stop
loss point if the trade goes bad. Write this number down and honor
it—cut your losses—this is the most important thing for the trader to
know, even if you get whipsawed and it rallies right back. It did not do
what you expected it to do at the time you pulled the trigger–this is
the most important thing to remember.
• Make sure all things are in your favor, market direction, group direction,
sister stock direction and the exact timing is in place.
• At this point, the trader must then assume the status of an automaton,
a robot, and he must then follow his rules.
Remember that no trader’s judgement is infallible; if it were always
correct, that person would soon be the richest on this planet. But it is not
the case—we all make mistakes, and we will continue to make mistakes
in our lives and in the stock market! The rewards can be enormous if we
can learn to “cut the losses quickly and let the profits ride.”
Points Are a Key to Money Management
Livermore wanted at least the opportunity of a 10 point gain in any stock
he invested in.
Potential profit points were key in his trading. He was well aware that
if a stock goes from $10 to $20 it is a 100 percent gain, whereas a stock
that goes from $100 to $200 is a hundred point gain, as well as a hundred
percent increase in value.
He always bought in round lots and used his probing technique to buy:
1. An initial position of 20 percent,
2. A second position of 20 percent,
3. A third at position of 20 percent, and
4. A final purchase of 40 percent, with all purchases being at a higher
price and therefore higher cost.
This proved to him that the stock was moving in the direction he wanted
it to.
As previously explained, the main challenge for the trader is to identify
the current market leaders and to spot the new market leaders who
are waiting to take over from the current ones. During major shifts and
changes in market direction, it is of paramount importance for the trader
to observe the leaders that are being driven out and identify the new
stocks that will assume leadership in the future.
It is usually always best to go with the strongest stock in the strongest
group—do not look for the cheapest or the laggard stock that has not yet
had his turn to move in the group—always go for the strongest most dominant
stock in the group.
Livermore’s Method of Pyramiding
The trader must learn: You never average down.
That is, if the stock you bought goes down in price—do not buy any
more and try to average your price—it hardly ever works. But what
does often work is “averaging up” in price—buying more as the stock
goes up in price. But this can be dangerous also, so try to establish your
main position at the beginning, at the initial Pivotal Point, and then increase
it at the Continuation Pivotal Point—providing the stock comes
out of the consolidation with strength. The trader must wait until the
stock has proven it is going to break out on the strong side of the Continuation
Pivotal Point; until the stock declares itself, it is always a risk. At
these junctures the trader must watch like a hawk and stay poised, but
not biased by hope.
The final time a trader can pyramid is when a stock breaks out to a
clear new high, especially if it moves on heavy volume (see Figure 5.1);
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.
All pyramiding in the stock market is a dangerous activity, and anyone
who tries it must be very agile and experienced, for the further a stock
moves in its rise or decline the more dangerous the situation becomes.
To offset the risk, Livermore tried to restrict any serious pyramiding to the
beginning of the move. He found it unwise to enter a pyramiding action if
the stock was far from the Pivotal Point base—better to wait for the next
Continuation Pivotal Point or the break-out to a new high.
The trader must always remember there are no ironclad rules to the
stock market, the main objective for the stock speculator is to try and
place as many factors in his favor as he can. And even with these in place,
the trader will still be wrong on many occasions, and he must react by cutting
his losses.
Here is a money management rule that cannot be stated often enough:
A trader should always keep some cash in reserve for those incredible
moments in trading the market when all the factors come together to form
the “Supreme Trade at the Perfect Moment” such as occur at the zenith of
bull markets and the nadir of panics. Many of these trading moments have
recently occurred in 2003, and more still remain for 2004. There is no better
feeling than having a strong army of cash standing by, waiting for your
command to move into action.
Profits: The Spine of Every Stock
There is no magic about achieving success in the stock market. The only
way for anyone to succeed in investments is to investigate before investing;
to look before he leaps; to stick to the fundamentals of his own personal
list of rules, and disregard everything else. But, of course, first he
must establish his list of trading rules. Jesse Livermore was one of the
most successful traders in history. In this section, the trader is getting a
look at his money management rules.
Livermore would say to today’s trader: “Take my rules and try them. I
established them after having made many mistakes and thousands of
hours of analysis and they work. If I can save you the pain and expense I
endured, I will be happy to have done so.”
Every trader must also understand that, in the end, in the final
analysis, when the dust settles on a stock, it is the earnings—profits,
and profit potential—that actually establish the final price of the stock.
This happens when the emotions are wrung out and reality finally does
settle in. But the trader must also understand that it is always hope and
greed that grease the skids, lubricate the wheels of volatility on the
stock’s journey. The promise of superior earnings may have driven the
stock in its history. But in the final analysis, it is real profits and real results
that eventually cause the price of stocks to settle. Reality will always
eventually set in to produce a final conclusion for the industry
group and any particular stock. This will be revealed to the skilled technical
trader as it occurs.
Don’t Give Your Money to Others to Trade
It has become apparent in today’s modern scandal-ridden markets that
there is no security or safety in trading in the shares of large blue-chip
companies or listening to highly accredited analysts, or trusting old, steadfast
mutual funds. Where big money is concerned, there is always the danger
of illegal activities lurking in the background. And there is no more
money at stake than in the American stock markets.
The gangsters, the con men, the thieves, the swindlers, the grifters, all
know where the money is and are always thinking of ways to help themselves
to the stock trader’s money. This comes as an additional burden in
the field of stock trading, which is a most difficult field to begin with—a
place where only the skillful, disciplined trader has a chance.
Here is one of Livermore’s famous sayings: “If I am going to lose my
money in the stock market, as so many people do . . . then I would prefer
to lose it myself. I do not need a broker to lose it for me.”
When you are handling surplus income, do not delegate the task to
anyone. Whether you are dealing in millions or in thousands, the same
principal lesson applies. It is your money. It will remain with you just so
long as you guard it. Faulty speculation is one of the most certain ways of
losing it.
Blunders by incompetent speculators and traders cover a wide scale.
Livermore warns strongly against averaging losses. That is a most common
practice. Great numbers of people will buy a stock, let us say at 50,
and 2 or 3 days later if they can buy it at 47 they are seized with the urge to
average down by buying another hundred shares, making an average price
of 48 on all.
Having bought at 50 and being concerned over a three-point loss on a
hundred shares, what rhyme or reason is there in adding another hundred
shares and having the double worry when the price hits 44? At that point,
there would be a $600 loss on the first hundred shares and a $300 loss on
the second hundred shares.
If one is to apply such an unsound principle, he should keep on averaging
by buying 200 shares at 44, then 400 at 41, 800 at 38, 1600 at 35,
3200 at 32, 6400 at 29, and so on. How many speculators could stand
such pressure? Yet if the policy is sound, it should not be abandoned. Of
course, abnormal moves such as the one indicated do not happen often.
But it is just such abnormal moves against which the speculator must
guard to avoid disaster.
So, at the risk of repetition and preaching, avoid averaging down. Livermore
received one sure tip from a broker concerning a margin call:
When the margin call reaches you, close your trade—never meet a margin
call. This proves you are on the wrong side of the market. Why send good
money after bad? Keep that good money for another day. Risk it on something
more attractive than an obviously losing deal.
A successful businessman extends credit to various customers, but
typically would not sell his entire output to one customer. The larger the
number of customers, the more widely the risk is spread. Just so, a person
engaged in the business of speculation should risk only a limited amount
of capital on any one venture. As stated, cash to the speculator is like merchandise
on the shelves of the merchant.
One major mistake of all speculators is the urge to enrich themselves
in too short a time. Instead of taking 2 or 3 years to make 500 percent on
their capital, they try to do it in 2 or 3 months. Now and then they succeed.
But do such daring traders keep it?
They do not. Why? They do not take some money off the table from
time to time.
This one rule haunted Livermore because he did not always adhere to
it. In fact, he consistently broke it. When he made a large profit in a trade,
he did not take some of the profit off the table, out of the market and put it
in the bank. It was one of the major regrets of his trading years.
Most people do not think they earned the money they make in the
market because all they have done is make a phone call and shuffle some
paper. There is no actual work involved in trading, no service being offered
such as a doctor, mechanic, carpenter, plumber provides, nothing
being manufactured like a lawn mower, a car, a suit of clothes. As a result,
a lot of people have trouble psychologically, it appears to them as unhealthy
money, rolling in rapidly, and stopping for but a short visit. The
speculator in such instances loses his sense of balance. The uninitiated
public investor says: “If I can make 500 percent on my capital in 2 months,
think what I will do in the next 2! I will make a fortune with basically no
work. I call, place my order with the broker, and collect my profits—it’s no
wonder rich people play the stock market.”
Such speculators are never satisfied. They continue to shoot the
works until somewhere a cog slips, something happens—something drastic,
unforeseen, and devastating. At length comes that final margin call
from the broker, the call that cannot be met, and this type of plunger goes
out like a lamp. He may plead with the broker for a little more time, or if
he is not too unfortunate, he may have saved a nest egg permitting a modest
new start.
Businessmen opening a shop or a store would not expect to make
over 25 percent on their investment the first year. But to people who enter
the speculative field 25 percent is nothing. They are looking for 100 percent.
And their calculations are faulty; they fail to make trading a business
and run it on business principles. In the end, Livermore believed that 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 trade.
Livermore used to tell this story to his friends:
“I recall one day in Palm Beach. I left New York with a fairly large
short position open. A few days after my arrival in Palm Beach the market
had a severe break. That was an opportunity to cash paper profits into real
money—and I did.
“After the market closed I gave a message to the telegraph operator to
tell the New York office to send immediately to my bank one million dollars
to be deposited to my credit. The telegraph operator almost passed
out. After sending the message, he asked if he might keep that slip. I inquired
why.
“He said: I’ve been an operator here in Palm Beach for twenty years
and that was the first message I ever sent asking a broker to deposit in a
bank money for the account of a customer.
“He went on: I’ve seen thousands and thousands of messages passing
over the wire from brokers demanding margins from customers. But
never before one like yours. I want to show it to the boys.”
The only time the average trader can draw money from his brokerage
account is when he has no position open or when he has an excessive equity.
He won’t draw it out when the markets are going against him because
he needs all his capital for margin.
He won’t draw it out after closing a successful deal because he says to
himself: “Next time I’ll make twice as much.”
Consequently most speculators rarely see the money. To them, the
money is nothing real, nothing tangible. For years, after a successful deal
was closed, Livermore made it a habit to draw out cash. He would draw it
out of the market at the rate of $200,000 or $300,000 a clip. It had a psychological
value for Livermore. He made it a policy to count the money
over again. It was then that he knew he had something in his hand. He felt
it. He spent a little. He knew his hard work was producing real money.
For Livermore, money in a broker’s account or in a bank account was
not the same as if you felt it in your own fingers once in a while. Then it
meant something. There is a sense of possession that makes you just a little
bit less inclined to take headstrong chances of losing your gains. So
every trader should have a look at his real money once in a while, particularly
between market deals.
Livermore was unable to make any money outside of Wall Street. In
fact, he lost many millions of dollars, which he took from Wall Street and
invested in other ventures, such as real estate in the Florida boom, oil
wells, airplane manufacturing, and the perfecting and marketing of products
based on new inventions. He always lost every cent.
In one of these outside ventures that had whipped up his enthusiasm,
he sought to interest a friend of his in investing $50,000. His friend listened
to his story very attentively. When Livermore finished, the friend
said: “Livermore, you will never make a success in any business outside of
your own. Now if you want $50,000 with which to speculate it is yours for
the asking. But please trade stocks and stay away from business.” The
next morning, to his surprise, the mail brought a check for that amount,
which Livermore did not need and sent back.
The lesson here again is that trading stocks is itself a specialty business
like any other, and should be so viewed by all who wish to trade in
the market. Do not permit yourself to be influenced by excitement, flattery,
or temptation. Keep in mind that brokers sometimes innocently
become the undoing of many traders. Brokers are in the business to
make commissions. They cannot make commissions unless customers
trade. The more trading, the more commissions. The speculator wants
to trade, and the broker not only is willing, but too often encourages
over trading. The uninformed trader regards the broker as his friend and
is soon over trading.
Now if the speculator were smart enough to know at just which time
he should over trade, the practice would be justified. He may know of
times when he could or should over trade. But once acquiring the habit,
very few traders are smart enough to stop. They are easily carried away
emotionally, and they lose that peculiar sense of balance so essential to
success. They never think of the day when they will be wrong. But that
day always arrives. The easy money they might have made takes wing, and
another trader goes broke.
Follow the rules—never make any trade unless you know you can do
so with financial safety.
POSTSCRIPT
Many legends about Jesse Livermore have persisted over the years. In my
research on Livermore, the following story was told to me by Patricia Livermore,
his daughter-in-law, married to Jesse Jr., and then again by Paul
Livermore, Jesse’s younger son. I have written it down faithfully as it was
told to me.
Livermore’s Annual New Year’s Ritual
“Good afternoon, Mr. Livermore.”
“Hello, Alfred.”
It was the Friday before the New Year of 1923. Livermore walked into
the Chase Manhattan Bank, late in the afternoon. He was warmly greeted
by Alfred Pierce, the bank manager. Livermore was one of the bank’s best
customers, keeping a balance of at least two million dollars in reserve for
his special “stock situations,” when he needed extra cash to establish one
of his famous stock purchases or perhaps engage in a raid or activate a
commodity corner.
“We have everything ready for you, J.L.,” Alfred said. (People who
knew Livermore well called him J.L.)
Livermore looked at his watch—it was almost 5:15. The bank was already
closed. They had let him enter the bank through the employees’
door. “Yes, J.L., the closing bank vault time-lock is set for 5:30, as always.”
They walked in silence across the great vaulted room of the main
branch through the door that separated the tellers’ cages from the public
and entered the back of the bank.
“And Monday morning?” Livermore asked.
“Monday, the timer on the vault is set to open at 8:00 sharp, like
always.”
“I just like to be sure.” Livermore added with a smile.
“I understand, J.L.—by that time you will have had enough solitude.”
“Yes Alfred, of that I am sure.” Livermore said. He was carrying a
leather briefcase. Alfred looked at the briefcase. “Do you mind me asking
what’s in the briefcase?”
“Not at all. It is my entire trading history for 1923. I will review every
trade I made and refer to my notes. I keep good notes on all my trades that
explain why I bought or went short and why I closed my positions.”
“So you don’t win every time?” Alfred said facetiously.
“Alfred, there are many rumors about me; of course, you know that I
lose. I am only human. The idea is to get out fast when a trade goes
against you. I often lose, that is what I am trying to figure out this weekend—
why did I lose on certain trades over the year.”
They approached the main vault. It was huge with a giant solid steel
door. Two armed security men stood on either side of the door. They nodded
at Alfred and Jesse Livermore. They knew what was going on.
The two men crossed over the threshold and entered the cavernous
vault. There was a large amount of cash in a series of open chests. Most of
the bills were hundreds with one chest full of twenties and fifties. There
was a desk, a chair, a cot, and an easy chair in the middle of the cash.
There was a special light above the desk and a second light above the easy
chair. Livermore went over to the cash in the open chests and looked
down at the uncovered bills. “There is almost fifty million here. The exact
amount is written on the pad on your desk. The last of it came over from
E. F. Hutton’s this afternoon.”
Jesse Livermore had sold out almost every position he had in both
stocks and commodities, as he did at the beginning of every new year. He
stared down at the cash.
“I would like to have the commission on just these sales, J.L.,” Alfred
said.
“This is not all of it. In some cases the market was too thin to take the
hit, so that stock will be sold slowly over the next few weeks or so, and
will be sent here for safekeeping.”
“When will you resume trading?”
“Most likely in February, after I get to Palm Beach.”
The red light on the ceiling started to flash and a low-level bell rang at
20-second intervals. The bank manager looked at his watch.
“Five minutes before the vault closes, J.L. The food is over here.”
The bank manager went to an icebox in the corner. “We got everything
that your office manager Harry Dache ordered for you. He actually
brought the food over himself about an hour ago, and we had an ice delivery
around noon. Bread, cold cuts, vegetables, water, milk, juices and
the makings for some old fashioneds.” Alfred pointed into the open icebox
door.
“Thanks, those old fashioneds will come in handy.”
“Right you are, J.L. I’m going to leave now, I suffer from claustrophobia
and all this money scares me.”
Livermore walked the bank manager to the vault door. They shook
hands. “J.L. if anyone ever knew about this . . . well . . . they might think
that you were eccentric.”
“Eccentric is a kind word, Alfred.” Jesse Livermore smiled as the
door started to swing shut, pushed by the two armed guards. “You see, Alfred,
all year long all I see is and endless stream of paper. This weekend
makes it real for me . . . real cash—nothing like it.
Livermore stood at the door as it clanged shut. The lights above the
desk and the easy chair now provided an eerie but adequate light. Livermore
surmised that no one had ever actually tested them with the door
shut; no one would volunteer to be locked inside the vault.
He turned and walked to the desk surrounded by almost fifty million
dollars in cash. For the next two days and three nights this would be his
home. Inside the cavernous vault he would retreat into deep solitude and
review his entire trading year from every aspect . . . just as he had done
every year since he had started trading.
When it was time to leave on Monday morning he would go to the
chest that held the twenties and the fifties and stuff his pockets with
as much cash as he desired, and over the next two weeks he would
spend it.
He had not locked himself up with his cash as a miser might lock himself
up to count his money in the counting house. No, Livermore, because
his world was a world of paper transactions all year long, believed that by
the end of the year he had lost his perception of what the paper slips really
represented—cash money, and ultimately, power.
By the end of the year, he was just shuffling paper. Livermore
needed to touch the money and feel the power of cash. It also made him
reappraise his stock and commodity positions and determine: Were
these positions he would keep if he had the choice—were there better opportunities?
Selling everything out forced him to appraise whether or not
he would buy these positions back.
When he walked out of the vault on the Monday morning with pockets
full of cash, he would start his shopping spree, a spree that usually lasted
for at least a week and included spending on many human pleasures as
well as material items.
Labels: Reference, Risk Management, Stock Trading System
