fty milliondollars in cash. For the next two days and three nights this would be hishome. Inside the cavernous vault he would retreat into deep solitude andreview his entire trading year from every aspect . . . just as he had doneevery year since he had started trading.When it was time to leave on Monday morning he would go to thechest that held the twenties and the ﬁfties and stuff his pockets withas much cash as he desired, and over the next two weeks he wouldspend it.
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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, becausehis world was a world of paper transactions all year long, believed that bythe 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. Livermoreneeded to touch the money and feel the power of cash. It also made himreappraise his stock and commodity positions and determine: Werethese positions he would keep if he had the choice—were there better opportunities? Selling everything out forced him to appraise whether or nothe would buy these positions back.When he walked out of the vault on the Monday morning with pocketsfull of cash, he would start his shopping spree, a spree that usually lastedfor at least a week and included spending on many human pleasures aswell as material items.
CHAPTER 6
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he market is driven by psychological factors, not logic. A stocktrader is caught in a maelstrom of thoughts and emotions once hehas pulled the trigger on a trade. It is in this area that most of thegrief occurs for the trader. So far, we have studied the Livermore TradingSystem’s approach to timing and money management. We’re left with thismost important section—emotional control. Once we have made a trade,how do we control the myriad of emotions and thoughts that can easilycause us to make bad judgments and nullify all the other good work wehave done up to the execution of the trade? No one is exempt from theemotional part of the trading equation with its pitfalls and dangers, including Jesse Livermore.Livermore had an unquenchable thirst for knowledge about his chosen profession, and all his working life he was a constant student of thestock market. He was also a great student of the psychology of the market. At one point, he took psychology courses at night school in New Yorkto better understand human nature. Livermore drew a conclusion fromhis studies: There may be millions of minds at work in the market, butthere were basically only a few psychological patterns that had to bestudied and understood—since human nature in market dealings is primarily driven by the common emotions of fear and greed, this leads tocommon traits of human behavior when buying and selling. In the stockmarket, this ultimately equates to common numerical and chart patterns.(See Figure 6.1.)97
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Figure 6.1 An illustration of the Human Mind.
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Later in his life he was asked an important question by his sons, Pauland Jesse, Jr.:“Dad, why are you so good in the market and other people lose alltheir money?”He said, “Well, boys, I have also lost money, but each time I lost, I triedto learn why I had lost. The stock market must be studied, not in a casualway, but in a deep, knowledgable way. It’s my conclusion that most peoplepay more care and attention to the purchase of an appliance for theirhouse, or to buying a car, than they do to the purchase of stocks. Thestock market, with its allure of easy money and fast action, induces people into foolishness and the careless handling of their hard-earned money,like no other entity.“You see, the purchase of a stock is simple, easily done by placingyour buy order with a broker; later a phone call to sell completes thetrade. If you proﬁt from this transaction, it appears to be easy money withseemingly no work. You didn’t have to get to work and labor for eighthours a day. It was simply a paper transaction, requiring what appears tobe no labor. It gives the clear appearance of an easy way to get rich. Simply buy the stock at $10 and sell it later for more than $10. The more youtrade, the more you made, that’s how it appears.“Simply put, it’s ignorance.”The boys listened attentively, but they never had any interest in trading the market like their father.A stock trader must constantly deal with emotions—when things gobad, there’s often fear to deal with. Fear lies buried just beneath the surface of all normal human life. Fear, like violence, can suddenly appear inyour life in the space of a single heartbeat, a fast breath, a blink of the eye,the grab of a hand, the noise of a gun. When it appears, natural survivaltactics come alive, normal reasoning is distorted. Reasonable people actunreasonably when they are afraid. And people become afraid when theystart to lose money; their judgment becomes impaired. This is our humannature in this stage of our evolution. It cannot be denied. It must be understood, particularly in trading the market. Sooner or later, fear will come tovisit every stock trader who actively trades the market.The unsuccessful investor or trader is usually best friends withhope—when it comes to the stock market, hope skips along the trader’spath hand in hand with greed, but fear is always trailing along as well, hiding in the shadows.Once a stock trade is entered, hope springs to life. It is human natureto be hopeful, to be positive, to hope for the best. Hope has been and willalways be an important survival technique for the human race. But hope,like its stock market cousins ignorance, greed, and fear, distorts reason.
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The trader must be acutely aware that the stock market only deals infacts, in reality, in cold numbers; the stock market is never wrong—traders are wrong. Similar to the spinning of a roulette wheel, the littleblack ball tells the ﬁnal outcome—not greed, fear, or hope. The ﬁnal resultof stock market trading, which is posted in the newspaper at the end ofevery day, is objective and conclusive, with no appeal, like pure nature inthe raw, a life and death struggle.Livermore believed that the public wanted to be led, to be instructed, to be told what to do. They wanted reassurance. He believedthat they would always move en masse, a mob, a herd, a group, becausepeople want the safety of human company. They are afraid to standalone because the belief is that it is safer to be included within the herd,not to be the lone calf standing on the desolate, dangerous wolf-patrolled prairie of contrary opinion—and the truth is that it usually issafer to go with the trend.This is where it gets slightly complicated for most traders. Livermorewas an independent thinker, yet he always wanted to trade along the lineof least resistance—the trend, so he was generally moving along with thecrowd, the herd, most of the time. It was when the change in trendstarted to appear, the change in overall market direction—that was themost difﬁcult moment to catch and act upon.He was always on the hunt for the clues to recognize a coming changein basic trend, looking for the Pivotal Point to form. A trader can never become complacent. Livermore was always alert, ready, prepared to separate himself from the popular thinking of the moment, the group thinkingthat usually always drives the market, and to go in the opposite direction.Livermore believed in cycles. There is a time when things are goodand a time when things turn bad. It is true in this life for all of us, and it istrue in the stock market. The good times are coming and so are the badtimes—the question for a successful trader is not will they come...it iswhen will they come? Livermore’s conclusion—usually when you least expect it, the trend will change.The change in trend is the most difﬁcult time in a speculator’s tradinglife. These major changes in trends were and remain hell. But Livermoreknew these were the points where most of the money was lost, as was justexperienced from 1999 to 2002. It is best to avoid the downhill slide ofstocks, unless you have sold stocks short. There is always a way to makemoney in the stock market.With this in mind, Livermore developed two rules:First, do not be invested in the market all the time. There are manytimes when you should be completely in cash, especially when you are unsure of the direction of the market and waiting for a conﬁrmation of the
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next move. In Livermore’s later life, whenever he deduced that a changewas coming, and he wasn’t sure exactly when or how severe the changemight be, he cashed in all his positions and waited.Second, it is the change in the major trend that hurts most speculators. They simply get caught invested in the wrong direction, on thewrong side of the market. To determine if you are right in your appraisalthat a change in market trend may be coming use small position probes byplacing small orders, either buy or sell, depending on the direction of thetrend change you anticipate occurring. This will test the correctness ofyour judgment. By sending out exploratory orders and investing realmoney, you will get the signal that the trend is changing because eachstock purchase will be at a cheaper price than the prior purchase—thesignal—prices are dropping—time to go short.The trader’s job is to continually observe the tape and to interpret thetape as a person would look at a movie with no two frames exactly thesame. No two markets are ever exactly the same, but they all have similartraits, like humans. These individual messages must be extracted from thetape and run through your brain in a rapid fashion.The stock market always follows the line of least resistance until itmeets with an at-ﬁrst almost imperceptible force that slowly, but inexorably, stops its upward or downward momentum. It is at these key junctures—recognizing the Reversal Pivotal Points—being able to identifythem and not be confused by natural reactions or the appearance of Continuation Pivotal Points—that the real money is made.Just as the panics always encouraged Livermore to go long whenthings looked the bleakest, conversely, when everything looked perfectand blissful, it occurred to him that it might be time to go short. He triedto see this before everyone else did. That is why he kept his own counselin silence and avoided, whenever possible, talking to anyone who mightalter his thinking.Sometimes, Livermore accumulated his line of stocks at what he believed to be the turning point in a great decline or at the crest of a mightyupward wave. He understood that it required time for general business torecover and for the earning power of these stocks to be reinstated, and sohe was patient and prudent in assembling his line of stocks for either anew rally or in going short in a downward trading market.He started trading at age 15 in the stock market. It was the focus of hislife. He was very fortunate in calling the Crash of 1907 almost to the actualhour and very ﬂattered when J. P. Morgan sent a special envoy to ask himto discontinue his short selling, which he did.On his best single day during the Crash of 1907, he made $3 million.He was also prescient in his trading during the Crash of 1929 when he
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decided to go short with the market at its very zenith, he proﬁted by$100 million.But at ﬁrst in the great collapse of the market in 1929, he went tothe short side too early with the motors (car companies) as they rolledover—he lost over a quarter million dollars before he ﬁnally found thecorrect Reversal Pivotal Points as the key market leaders of the timerolled over and tumbled headlong into the great crash. He went short inearnest at that moment and increased all his positions. During theCrash of 1929, he made the largest amount of money he had made. Hewas blamed personally by the press and the public for the crash, whichwas pure nonsense. Nobody—no single person—could cause a marketto do something that it did not want to do. Nevertheless, his life wasthreatened, and he was forced to protect his family with special security measures.By 1929, Livermore had been trading for almost 40 years and had aﬁnely developed intuition resulting from his enormous experience. Buthe later explained that, in retrospect, in all these cases the clues wereevident in the actions of the stocks and spoke to him as clearly as canbe imagined.For Livermore, the people who invest in the market are akin to a largeschool of bait ﬁsh who have no speciﬁc leader, and they are capable ofvery quick, random action whenever they fear they are in danger. In otherwords, there are millions of minds involved in the stock market, theseminds form decisions based on the two main emotions in the stock market, hope and fear. Hope is often generated by greed; fear is often generated by ignorance.Livermore’s main success emanated from his ability to ﬁnd the mainturning points, the Reversal Pivotal Points. In the long-term trends, this isthe most crucial and important thing a stock trader must do. He was alsoconvinced that if a trader, during the panics and the booms, was able toaccurately ﬁnd the perfect psychological moment (the pivot points) toexit and enter the market he could amass a fortune of great proportion.For a successful trader must be able to ﬁnd and trade in the direction ofthe momentum—the direction of the line of least resistance. Livermorenever had a problem in playing either side of the market (bull or bear, although he did not use these terms) because it was only logical to him,since he believed in cycles, that there were always going to be times to golong and times to also go short. The market goes up a third of the time,down a third, and sideways a third of the time.If Livermore was exiting a long position, because he believed thestock has topped out, it was easy for him to consider getting on theshort side of that same stock. He had no feelings for a stock, as somepeople do.
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For instance, if a trader has made money with General Motors on thelong side, the trader should have no emotional feelings for General Motors—the stock has simply done what the trader deduced it would do. Ifthe trader can now make a proﬁt as General Motors declines—by goingshort—he should do so with no feeling toward the stock, which is after allan inanimate thing with no feelings for the trader. There are no goodstocks, nor are there any bad stocks; there are only stocks that make (orlose) money for the speculator.Livermore had heard many of his fellow traders say: “That stock wasgood to me.” Or “That stock cost me money, so I am staying away from it!”The stock had nothing to do with it. Everything that happens is a result ofthe trader’s judgment and no excuses are acceptable. To put it simply, it isthe trader or speculator who makes the conscious decision to enter atrade, and it is always the trader who makes the conscious decision to exita trade. The judgment was either correct or it wasn’t.All traders must beware of a kind of arrogance, for when a stockmoves against us we must decide that we were wrong and must exit thattrade instantly. Most traders forget that it is a proven fact that we will always be wrong on some trades. It is getting out of those trades quicklythat is the key to success.Another trap the inexperienced trader must deal with is trying toﬁnd the exact bottom and top of a major trading cycle. Remember,there are times when a trader must be out of the market and waiting onthe sidelines. It is virtually impossible to call the exact top and the bottom of any market, but it is much better to err on the side of caution.Getting out and waiting for the market to establish itself is very difﬁcultwhile you are invested, because by being invested you will have an automatic bias toward the direction of your position. This bias stems fromthe hope. If you are long, you will subconsciously favor the long side, ifyou are short, you will subconsciously favor the downside. Hope livesin us all; remember, it is human nature to be hopeful. That is why Livermore often sold out all his positions and reevaluated the market from acash position. It cost him the commissions, but he viewed this as asmall insurance premium cost toward the overall proﬁt goal. It is notwhat the millions of people think about the market, or say about themarket . . . no, no, no, it is what they do about the market by their actualbuying and selling; all this is immediately revealed on the tape; theproblem is in the interpretation of this news, this evidence, as the tapeﬂows past the reader.This was Livermore’s business, his life’s vocation and the thing hemost enjoyed. The work of solving the puzzle was what always fascinated him. It was never the money—it was solving the puzzle, the moneywas the reward for solving the puzzle. Going broke, which happened to
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him several times in his life, was the penalty for not solving the puzzle.The chief deception is that trading the market looks easy when it is oneof the most difﬁcult things to do—anticipate the trend. We must beaware of our emotional ﬂaws and have the discipline to control and conquer the weaknesses of our human nature. It is the most difﬁcult task atrader faces.As Livermore explained to his sons: “I lost money when I broke myown rules—when I followed my rules, I made money.”
HOW TO KEEP YOUREMOTIONAL CONTROL INDEALING WITH MEDIA NEWSLivermore was always suspicious of everything he read in the newspaperand never accepted what he read at face value. He tried to look for hiddenagendas and self-serving reasons that could have generated the articles,no matter what paper published the information. In Livermore’s time,many news reporters were convicted of trading against the news theywrote about a stock. The reporters were also fed pure ﬁction, actual lies,by insiders to hype the stock.He always tried to read between the lines and formulate his own judgment; that is why he often preferred to be alone, to formulate his ownopinions and to use his own judgment when reading the newspapers. Hedid not seek the opinions of others in dealing with news releases. He triedto look below the surface.Livermore told a friend: “I interpret these newspaper articles in twoways. First, I try to interpret their immediate and direct inﬂuence on theopinions and actions of stock traders with regard to a particular stock.Second, I watch the actual stock quotes to detect how the news has inﬂuenced the buying and selling of speciﬁc stocks as a whole in that marketindustry group. Often my interpretation of a news event is wrong. But I always know that if the news development is of sufﬁcient importance it willeventually affect the tape.“In other words, I watch the tape like a hawk to see how it is reactingto actual news. I do not listen to people, the pundits, the reporters, the analysts who are trying to interpret the news item and predict what will happen to a stock, an industry group, or the overall market.“It is my experience that it is far better to look objectively at the tape,for the tape will provide the actual facts as to how the public is reacting tothe news. These actual facts revealed by the tape are a far better indicatorthan any reporter or pundit can provide. It is up to the skillful market
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trader to watch the tape and react only to what the tape is saying. Learnhow to read the tape—the truth is in the tape—listen to it. Try and avoidthe opinions of so-called-experts.”One of the problems with looking too deeply into economic news isthat it may plant ‘suggestions’ in your mind, and suggestions can be subliminal and dangerous to your emotional stock market health whereyou have to deal in reality, not supposition. These suggestions are veryoften logical, but that does not mean they are true and will necessarilyaffect the market. Logic does not drive the market. It is driven by human emotion.
CUT YOUR LOSSES, LET THE WINNERS RIDENote: This conversation and story are excerpted from The Amazing Lifeof Jesse Livermore: World’s Greatest Stock Trader by Richard Smitten.The conversation, held at lunch, was between Jesse Livermore, WalterChrysler (Chrysler Motors), Ed Kelley (head of United Fruit Co.), T. Coleman DuPont (DuPont Family), and Colonel Ed Bradley of Bradley’sCasino in Palm Beach (Bradley was the owner of the longest running illegal gambling club in the United States).
“I’ve been hearing rumors on the Street about you and a wheat trade. Tellus about it, J.L., entertain us at lunch.”“Well, I just felt the demand for wheat in America was underestimated, and the price was going to rise. I waited for what I call my PivotalPoint and stepped in and bought 5 million bushels of wheat, about 7 million dollars worth.“I watched the market closely after the purchase. It lagged. It was adull market, but it never declined below where I bought it. Then one morning the market started upwards, and after a few days the rise consolidated,forming another of my Pivotal Points. It laid around in there for a littlewhile, and then one day it popped out on the upside with heavy volume.“A good signal, so I put in an order for another 5 million bushels. Thisorder was ﬁlled at higher and higher prices. This was good news to me because it clearly indicated that the market line of least resistance was upward.“I liked the fact that it was much more difﬁcult to acquire the second lotof 5 million bushels. I then had ﬁlled out my predetermined target positionof 10 million bushels, so I stepped back, and kept my eye on the market. Itformed into a strong bull market and rose steadily for several months.(Continued)
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“When wheat rose 25 cents above my average price I cashed in. Thiswas a bad mistake.” Livermore paused as the lobster salads were servedand the second bottle of champagne was opened.Walter Chrysler asked, “J.L., how the hell could it be a bad mistake tomake a proﬁt of two and a half million dollars?”“Because, Walter, I sat back and watched wheat rise another 20 centsin price in three days.”“I still don’t get it,” Chrysler said.“Why was I afraid? Why did I sell? There was no good reason to sell thewheat. I simply wanted to take my proﬁt.”“It still looks like a pretty good trade to me. I’m afraid you lost me,J.L.,” Ed Kelley added.“All right, let me explain. You remember that old joke about the guywho goes to the race track and bets on the daily double and wins, thentakes all his winnings and bets it on the third race and wins. He does thesame on all the other races, and wins. Then on the eighth and ﬁnal race hetakes his hundred thousand dollars in winnings and bets it all to win on ahorse, and the horse loses.”“Yeah,” Chrysler nodded.“Well, he’s walking out of the track and he meets a pal of his, whosays. ‘How’d you do today?’“ ‘Not bad,’ he answers, smiling, ‘I lost two bucks.’ ”They laughed. “That’s a good story J.L., but how the hell does it applyto the wheat story?” Chrysler asked.“Simple—why was I afraid of losing the track’s money, my proﬁts? Ineffect, I was simply acting out of fear. I was in too big a hurry to convert apaper proﬁt into a cash proﬁt. I had no other reason for selling out thatwheat, except that I was afraid to lose the proﬁt I had made.”“What’s wrong with being afraid?” Dupont asked.“So, what did you do, J.L.?” Kelley asked.“Well, after I booked my proﬁt in the wheat I realized I had made agreat mistake. I had not had the courage to play the deal out to the end—’til I got a signal to sell, a real deﬁnitive sell signal.”“So . . . ?”“I re-entered the market and went back at an average price 25 centshigher than where I had sold out my entire original position. It rose another 30 cents, and then it gave a danger signal, a real strong danger signal. I sold out near the high of $2.06 a bushel. About a week later it soldoff to $1.77 a bushel.”“Well, you have more guts than me, J.L., and it sounds a little likegreed to me,” Ed Kelley said.
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“That’s because you sell fruit, Ed. The way you know how to diagnosethe market on fruit is the way I am supposed to know how to diagnose thestock and commodities markets, and the wheat futures market had shownno signs of weakness when I ﬁrst sold it.“The next time I sold the wheat it was different. I could see deﬁnitesymptoms of weakness. It gave the clues, the hints, the tell-tale signs oftopping out. The tape always gives plenty of warning time for the savvyspeculator to heed.”“Well, J.L., I like your story but sometimes I think maybe you got aset of those lucky horseshoes up your ass, just like Ed Bradley here,”Chrysler added.“Well Walter, a little luck never hurt anyone.” Livermore paused andlooked around at the group. “I’d say we all had our share of luck at onetime or another.”They all laughed.
THE WILLLivermore agreed with his friend, the gambler, Colonel Ed Bradley—aftertiming and money management comes emotions. It is one thing to knowwhat to do. It is quite another thing to have the will to actually do it. Thisis true of the stock market. This is true of life. Who knew better than JesseLivermore?Having the discipline to follow your rules is essential. Without speciﬁc, clear, and tested rules speculators do not have any real chance ofsuccess. Speculators without a plan are like a general without a strategy,and therefore without an actionable battle plan. Speculators without a single clear plan can only act randomly and they must react, to the “slingsand arrows of stock market misfortune.” This leads inevitably to thetrader’s defeat.Playing the market is partly an art form, it is not just pure reason. If itwere pure reason, then somebody would have ﬁgured it out long ago.That’s why every speculator must analyze his own emotions to ﬁnd outjust what stress level he can endure. Every speculator is different; everyhuman psyche is unique; every personality is unique and exclusive to anindividual. Learn your own emotional limits before attempting to speculate. If you can’t sleep at night because of your stock market position, then
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you have gone too far. If this is the case, then sell your position down tothe sleeping level.On the other hand, anyone who is intelligent, conscientious, and willing to put in the necessary time can be successful on Wall Street. As longas they realize the market is a business like any other business, they havea good chance to prosper.Until this latest decline in the market starting in 1999, many peoplebelieved making money in the market was easy. Yet most Americanswork, and anyone who works knows how hard it is to consistentlymake money in business, no matter what the business; it is never easyto make money. Livermore’s friends all had their own businesses. Hewould never ask his good friends like Ed Kelly, the head of the UnitedFruit Company, to tell him the secrets of the fruit business or WalterChrysler about the automotive business. It would just never occur tohim. So, he could never understand when people asked him the question, over and over again: “How can I make some fast money in thestock market?”He would smile and say to himself, “How could he possibly know howyou could make money in the market?” He always evaded the question. Hefelt it was the same as asking him “How can I make some quick money inbrain surgery? Or how can I make a few fast bucks defending some person in a murder case? He remained silent when asked because he believedthat even attempting to answer these questions affects a person’s emotions, because you have to take a ﬁrm position and actively defend yourrecommendations, which could change tomorrow, depending on the conditions of a dynamic stock market.But he fully understood that he was not the only one who knew thatthe stock market is the world’s biggest, most proﬁtable gold mine, sittingat the foot of the island of Manhattan. A gold mine that opens its doorsevery day and invites any and all people in to plumb its depths and leavewith wheelbarrows full of gold bars, if they can. And Livermore had doneit many times.The gold mine is there all right, and when the bell rings at the end ofthe day, someone has gone from pauper to prince, or from prince tosupreme potentate . . or stony broke. And it’s always there, the mountainof gold, waiting for the trader to pick up the phone and pull the trigger ona trade.Livermore truly believed that uncontroled basic emotions were thetrue and deadly enemy of the speculator: Hope, fear, and greed are always present, sitting on the edge of a trader’s psyche, waiting on thesidelines, waiting to jump into the action, plow into the game and messthings up.
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This is one of the reasons he never used the words “bullish” or “bearish.” These words were removed from his vocabulary because he believedthey create an emotional mindset of a speciﬁc market direction in atrader’s mind. Saying it’s a bull market or a bear market causes the traderto believe that is the direction of the market. And there is a good chancethe speculator will blindly follow that trend or direction for an extendedperiod of time, even if the facts change.Well-deﬁned trends often do not last for extended periods of time.When people asked Livermore for a tip, he would say, the market is currently in an “upward trend” or a “downward trend” or a “sidewaystrend”—or tell them that the “line of least resistance is currently up—ordown,” as the case might be. That is all he would say and even that oftengot him in trouble with the public, because he wasn’t around to tell themwhen the trend changed.This strategy left him with the ﬂexibility to change his mind, according to market behavior. He tried never to “predict” or “anticipate” the market, he only tried to “react” to what the market was telling him by itsbehavior.Always be aware that when stocks decline swiftly, and abruptly,they are being driven by fear. When they rise, they are being driven byhope. That’s why stocks go up slowly and fall rapidly. If people are hoping a stock will rise, they are slower to sell. If they fear the stock willdecline, they are usually fast to dump that stock. That is why declinesproduce faster, more abrupt market action. So, if you play the short sideyou must be ready to react to faster, more drastic market patterns andconditions.There is no good direction to trade, short or long, there is only themoney-making way. To sell short often goes against human nature,which is basically optimistic and positive. In 2003, less than 4 percent oftraders ever traded the short side of the stock market. There is also noquestion that it is extremely dangerous to sell short because the potential loss is unlimited. It takes strong control of your emotions to tradeon the short side.But the stock market moves up roughly a third of the time, sideways athird of the time, and downward a third of the time. If you only played thebull side of the market, you are out of the action, and your chance to makemoney, two-thirds of the time. And for good or bad, Livermore was not aman who wanted to wait, and hope, and wonder. He wanted to play thegame, and he wanted to win more times than he lost.Livermore was fully aware that, even in his time, of the millions ofpeople who speculate in the stock market, few people spend full time involved in the art of speculation. Yet, as far as he was concerned, it was a
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