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Mr. Hamilton, a private investor and contrarian analyst, publishes Zeal Intelligence, an in-depth monthly strategic and tactical analysis of markets, geopolitics, economics, finance, and investing…

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Wisdom of Jesse Livermore 8

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!

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