In his book "How to trade in stocks", Jesse Livermore, a famous speculator in the early 20th century and “the great bear”, discussed his trading method. Though Livermore died broke, we can still benefit from his forty-odd year experience in Wall Street. He emphasized to trade an unstoppable long-term trend and to get in somewhat near the beginning.
“Real movements do not end the day they start. It takes time to complete the end of a genuine movement.” p.29
“It has always been my experience that I never benefited much from a move if I did not get in at somewhere near the beginning of that move. And the reason is that I missed the backlog of profit which is very necessary to provide the courage and patience to sit through a move until the end comes-and to stay through any minor reactions or rallies which were bound to occur from time to time before the movement had completed its course.” p.46
Though Livermore was famous for his tape-reading and was regarded by many people as a technical trader, I think he was virtually a “techno-fundamentalist” as he digested lots of fundamental and market information in his normal trading days. After forming an opinion about the market or a particular stock, it is the TIMING he wanted to discuss in the book. Many of us probably have the experience of getting nothing out of the market though our opinion on the market direction was right. Maybe we get in the trend too late or we are scared out by a vigorous reaction. In the worst case we may have same experience as Jim Rogers’, who in 1970 shorted a stock at 48 and had to cover the position when the stock went up to 72. The stock eventually went up to 96 and then down to 2. Right but lost! Seems familiar? How could Livermore recognize the trend beginning?
“I determined to eliminate all the minor movements.” p.82
“I wanted to find out what constituted the beginning of a Natural Reaction or a Natural Rally. So I began checking the distances of price movements. First I based my calculation on one point. That was no good. Then two points, and so on, until finally I arrived at a point that represented what I thought should constitute the beginning of a Natural Reaction or Natural Rally.” p.83
There are around 20 pages in his book detailed his method. Here we only outline his idea and use the following figure as an example:
1. Up Trend: Suppose the stock is rising and we become bearish on the stock owing to some fundamental reason. We should not short at this stage and should wait for a better opportunity to short. At this stage, we only record the closing price in a column named “Up Trend” when it is higher than the last highest closing price.
2. Natural Reaction: How to eliminate minor movements? Livermore use DISTANCE to remove minor movements. If the stock closes significantly lower than the last highest closing price, it is in the Natural Reaction Stage. My definition of “significantly lower” for HSI is 10% of the last highest closing price in the column “Up Trend”. In this stage, we record in a column named “Natural Reaction” only when the closing price is lower than the last lowest closing price.
3. Natural Rally. When the stock closes significantly higher than the last lowest closing price in the column “Natural Reaction”, it is in the Natural Rally Stage. Now we have 2 pivotal points, the highest closing price in “Up Trend” and the lowest closing price in “Natural Reaction”. The price action around pivotal point deserves scrutiny. In this stage, we record in a column named “Natural Rally” only when the closing price is higher than the last highest closing price.
4. Livermore suggested shorting when the test of the highest closing price in “Up Trend” fails. My Definition of test failure for HSI is it closes around 5% lower than the last highest closing price in the column “Natural Rally”.
The above is only a simplified version of his recording method. His recording sheet consists of 6 columns, namely Up Trend, Down Trend, Natural Reaction, Natural Rally, Secondary Reaction and Secondary Rally, and handles many more scenarios, such as test success, fake test success etc. The following is my record of HSI using JL’s method. The minor movements were eliminated as illustrated.
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