sugar, and tobacco.Then along came the steels, and sugar and tobacco were nudged into thebackground. Every new market cycle has new market leaders, with few ifany of the old leaders remaining in the picture. Livermore believed itwould always be that way as long as there was a stock market.Note this Livermore trading rule: New leaders emerge with eachnew market. At this current moment, new leaders are moving into positions of leadership.Also note another Livermore rule: It is not prudent for a trader to tryand keep account of too many stocks at one time. You will become entangled and confused. Try to analyze comparatively few groups and fewstocks. You will ﬁnd it is much easier to obtain a true picture that waythan if you tried to dissect the entire market.If you analyze correctly the course of two stocks in the four or ﬁveprominent groups, you need not worry about what the rest are going todo. It becomes the old story of follow the leader . . . keep mentally ﬂexible. Remember the leaders of today may not be the leaders two yearsfrom now.The skilled trader will study only a limited number of groups and theleading stocks in each of those groups. He will learn to look carefully before he leaps. In other words, he will be patient. After 1920, a new age ofmarkets was ushered in—one that offered safer opportunities for the reasonable, studious, competent investor and speculator. There were technology improvements for that age with the invention of the widely usedticker tape, the telephone, and newspapers that provided a current recordof the stock trades and activity posted every day along with headlines andeditorials. This all helped traders and investors make intelligent decisionson what to buy.
DISCOVERY 2: UNDERSTAND INDUSTRYGROUP MOVEMENTSLivermore found that industry group movement was the key to individualstock movement. In the 1920s, he made a very important discovery that he
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applied to his trading system: Stocks did not move alone. When theymoved, they moved in sectors and industry groups. For Livermore, thiswas a huge breakthrough.If U.S. Steel rose, then sooner or later Bethlehem, Republic, and Crucible would follow. Livermore observed this time and time again, and itbecame one of the most important trading weapons in his arsenal. As a result, Livermore never tracked a single stock. He ﬁrst tracked the industrygroup movements. Livermore decided that a legitimate group movementhad to include at least the two leaders of the group, and eventually all thestocks in the group would follow.It is a commonplace mistake for traders of today to confuse IndustryGroups and Industry Sectors. In fact the media and traders often use theseterms interchangeably. It is very important to know the difference.Sector means all the industry groups within a particular section orarea. As examples, the Financial Sector includes a number of Groups, asdo the Computer, Communications, and Medical Sectors.In the Financial Sector, for example, there are national banks, regional banks, savings and loan banks, ﬁnancial service groups, stock brokers, and others. The Computer Sector includes, among others, boxmakers, software providers, makers of peripherals such as printers, monitors, and hand-held devices.Livermore believed that the most intelligent way to get one’s mind attuned to market conditions and to be successful in trading was to make adeep and through study of industry groups in order to differentiate thegood groups from the bad. The action result was this: Buy groups in apromising position and short Industry Groups that are not.It has been shown time and time again that on Wall Streetpeople very often fail to see the thing that is right in frontof them.—Jesse LivermoreCurrently there are more than 87 million Americans invested in thestock market in one form or another. It cannot be emphasized too stronglythe importance of ﬁrst understanding the Industry Group action beforethe purchase of any single security. It was a key to Livermore’s incrediblesuccess in trading the market. This key factor is understood by some oftoday’s market participants, but seemingly ignored by a large numbertraders and investors.Stay away from weak groups! Conversely, just as Livermore wouldhave avoided the weak stocks in the weak industry groups, he favoredthe strongest stocks in the strongest industries. The trader must, of course,be able and willing to revise any forecasts and positions in the light of
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developments that occur from day to day and to move quickly, if factorshave moved against him. This is just good common sense.
Why Industry Groups Move TogetherIf you were to ask today’s market pundits why industry groups move together, you would be subjected to a lengthy, probably convoluted, answer.Like many other aspects of his market views, the group movementpremise was quite simple to Livermore. He explained it in one sentence:“If the basic reasons are sound why U.S. Steel’s business should come intofavor in the stock market, then the rest of the steel group should also follow for the same basic reasons.” The converse to this premise, of course,also works for playing the short side of the market: When a group goes outof favor for a common basic set of reasons, just as it went into favor, itwill include all the stocks in that industry group.The industry group charts in Figures 3.1–3.3 illustrate the general di-
Figure 3.1 This is the ﬁrst in the series of industry group charts, all showingthe general direction of the group. This is the Internet Group.
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Figure 3.2 This is the second in the series of industry group charts, allshowing the general direction of the group. This is the Broker/Dealers Group.
rection of three current groups: The Internet Group, the Broker/Dealers,and the Housing Group.Note: It was also an important clue for Livermore that, if a particularstock in the favored group did not move up and prosper with the others,this could mean that perhaps this particular stock was weak or sick, andtherefore might be a good short sale or at the very least, the trader shouldbe cautious in buying it. It can act as a red warning ﬂag that the stock maybe in trouble.The only exception to group movement is when a single stock maycomprise over 50 percent or more of the total sales of the group, as is currently the case with Intel and Microsoft, who dominate their IndustryGroups. In these examples, you do not need to examine the two leadingstocks in the industry group; one will do the job, because sooner or laterthe rest of the group must follow the single dominant leader.
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Figure 3.3 This is the third in the series of industry group charts, all showingthe general direction of the group. This is the Housing Group.
Also note this may not always be the expected, conventional stock inthe group. Occasionally, a smaller, well-managed stock will assume leadership, perhaps with a new product or strategy, and may knock out the oldleader. Keep alert! Choose the most powerful stock in the group, not thebest bargain or a beaten down stock poised to recover.
DISCOVERY 3: TOP DOWN TRADINGThe concept of Top Down Trading is very straight forward, involvingfour steps.
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Step 1—Set Up the ChecklistBefore making any trade on any particular stock, you must ﬁrst check offthe following items:First, check the line of least resistance to establish the overall currentmarket direction. Remember, Livermore never used the terms bull or bearbecause they forced a mind-set that he believed made his thinking lessﬂexible. He used the term line of least resistance. He checked to see if thecurrent line of least resistance was positive, negative or neutral—sideways. Be sure to check the exact market the stock trades on—for instance, does the stock you are interested in trade on the Dow, the Nasdaq,or the Amex? Establish this before executing the trade.It is essential to make sure the lines of least resistance are in the direction of your trade before entering the trade. See Figure 3.4 where theNasdaq formed a pivot point and changed basic direction.
Figure 3.4 Here the Nasdaq formed a pivot point and changed basic direction.
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Step 2: Track the Industry GroupCheck the speciﬁc Industry Group. If you are considering a trade in AT&T,check out the Telecommunications Long Distance Group. If Haliburton isyour trade of choice, check out the Oil Well Drilling Group. If you arelooking at a trade in Harrah’s Entertainment, check out the Leisure Gambling Group. Make sure the group is moving in the correct direction, theline of least resistance, in order to increase your chance of a proﬁt on thetrade you have selected. In the example below, the trade is in the InternetIndustry Group.The Internet Industry Group began its recovery in February/March of2003, the same time as the Nasdaq. (See Figure 3.5.) In March/April, itgave a clear sign that the line of least resistance was upward. The signalsconﬁrmed each other that the trend was now to the upside.
Figure 3.5 The Internet Industry Group began its recovery in February/Marchof 2003, the same time as the Nasdaq.
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Step 3: Tandem TradingTandem Trading involves comparing two stocks of the same group. Compare the stock you’re interested in trading with the sister stock. For example, if you plan to trade in General Motors, check a sister stock such asFord or Chrysler/Mercedes. If you are going to trade Best Buy, than checkCircuit City—a sister stock.Tandem Trading Example: The stocks chosen for this example areMorgan Stanley and Merrill Lynch—the two leaders in the Broker/Dealer Group. Both stocks bottomed out in February/March of 2003and gave a signal, by pivotal point, that the line of least resistance waspositive. Because the broker/dealers are also often an important bellwether group for what the market may do in the future, this chart action (see Figure 3.6) was a precursor of what was to come in the overallmarkets.
Figure 3.6 Both Morgan Stanley and Merrill Lynch bottomed out inFebruary/March of 2003 and gave a pivotal point signal that the line of leastresistance was positive.
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Figure 3.6 (Continued)
Step 4: Examine All Three Factorsat the Same TimeLook at the market, the Industry Group, and the Tandem Industry Groupstocks in one glance. (The example of this is seen in the new LivermoreSoftware from Stock Market Solutions, on the opposite page.)In the example, it can be clearly seen how the system works, whenall factors are in unison. All the signals in Figure 3.7 (both market andstock) show a bottoming out in March/April and a reversal in trend,clearly indicating that the line of least resistance was now upward indirection.
NOTES FOR THE TRADERDue Diligence: Do a ﬁnal, thorough analysis of the individual stockyou have decided to trade. This step would be similar to traveling down
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Figure 3.7 All the signals (both market and stocks) show a bottoming out inMarch/April and a reversal in trend, clearly indicating that the line of leastresistance was now upward in direction. The group is the broker/dealers withMorgan Stanley and Merrill Lynch as the two leading stocks in that group.
the runway—but not lift off—a ﬁnal chance to change your mind before you pull the trigger and buy the stock. This ﬁnal step must becompleted by you, and you alone. Make this decision on your own—it’syour money.A military friend of mine, U.S. Navy Commander (Ret.) DennisKranyak, compares this approach of Livermore’s to the steps the U.S.Marines follow before they select a beach to assault. They study all thefactors on all the possible beaches. They analyze all these factors as carefully as they can with the full knowledge that the assault will not be perfect, no matter what the analysis reveals to them.There will always be unknown factors, the main one being the unpredictable human factor in assaulting a beach or playing the stockmarket . . . there is always the human factor to consider.
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Figure 3.7 (Continued)
Here are some Livermore Laws:• Wait until the preponderance of evidence is in your favor.• Use Top Down Trading.• Be patient! —Jesse Livermore
SUMMARYTandem Trading, the use of sister stocks, was one of the great secrets ofLivermore’s trading techniques and remains just as valid today as it did inyears gone by. This technique is an essential element in both Top DownTrading and in the maintenance of the trade after it has been completed.Livermore never looked at a single stock in a vacuum—rather, he lookedat the top two stocks in an Industry Group and did his analysis on both
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Figure 3.7 (Continued)
stocks. Understanding Top Down Trading, including Tandem Trading orsister stock trading, is essential to the successful use of the LivermoreTrading System. The overall conclusion was simple: both stocks had tohave the same pattern to initiate a trade in that group.Never look at only one stock—look at two—track two. Why? Becausestocks in the same group should always move together. Tracking twostocks instead of one adds a great conﬁrming psychological dimension toyour trading. You will discover when you visualize two stocks moving inunison that they conﬁrm the movements of each other. It is twice as hardnot to follow the correct signal when you see with your own eyes that thesister stocks actually move in tandem and therefore give you the absoluteconﬁrmation.It was this Tandem Trading technique that allowed Livermore to police his investments properly. Once the investment was made, Livermoreheightened his vigilance and continued his due diligence by daily observation of the two stocks.
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Figure 3.7 (Continued)
For Livermore, the evidence, the clues, the truth were always in themarket itself—quite visible if a person knew how to read them, the wayan experienced forensic investigator examines the details of a crimescene—clues become obvious to him that are visible to no one else. Theanswer lies in the market facts—the challenge for the trader is to properly interpret the facts that appear. He told his sons: “It’s like being agreat detective working on a great case that never ends—you neverknow it all!”Several other Livermore principles are at work in his Top Dawn Trading method and were part of his checklist:
Always trade with the trend. A trader should always have the trending wind at his back. Find the market that the stock is traded in(Dow, S&P, Amex, Nasdaq) and observe how the overall market istrading. For example, examine the line of least resistance or thetrend of the Nasdaq, if you are interested in trading Microsoft(MSFT) or Intel (INTC). Or examine the Standard and Poor’s 500(SPY’S) if you are interested in trading the top 500 stocks in America.The ultimate objective in the trade is to have the overall market
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trending in the same direction as your trade. You can trade short orlong as long as it coincides with the current trend at the time. Livermore never cared which side of the market he was on—short orlong—it was all the same to him. Only play the leading stocks in the leading Industry Groups. Inother words, only follow the leaders.
CALLING THE TOPS OF MARKETS USINGINDUSTRY GROUPS AND TOP DOWN TRADINGLivermore was asked many times how he called the top of the overall market, as he did in 1907 and 1929 when he made millions by going short. Hedid it using his Top Down Trading System along with his Industry GroupAnalysis method. This gave him the clues that enabled him to call thesemajor changes in market direction.It was Livermore’s experience that stock-group behavior is an important key to overall market direction, a key known by Wall Street, but ignored by most traders, whether they are big or small. He believed thegroups often provided the key to changes in trends. As the favored groupsof the moment became weaker and collapsed, a correction in the overallmarket was usually on the way. Note: The same thing happened in the 2000market collapse. The leaders ﬂipped and fell ﬁrst, and the others followed.
CHAPTER 4
Livermore PatternRecognitionTiming KeysPivotalPoint Trading
Pivotal Points are the perfect psychological moment to make atrade. Reversal Pivotal Points mark a change in trend.—Jesse Livermore
REVERSAL PIVOTAL POINTSReversal Pivotal Points are a key factor in the Livermore Trading System.Livermore was the ﬁrst person to use the term Pivotal Point and incorporate it as an important part of his trading system.He never wanted to buy at the lowest price or sell at the top. He wantedto buy at the right time and sell at the right time. The Pivotal Point Tradingtheory allowed Livermore the chance to buy at the right time. But this alsorequired him to have patience and wait for the perfect trading situation todevelop. If all the right conditions did not coincide on a particular stock hewas following, he didn’t care, because the proper pattern would sooner orlater appear on another stock. Patience . . . patience . . . patience—wait forthe perfect trade—that was his key to timing success.Livermore always considered time as a real and essential trading element. He often said: “It’s not the thinkin’ that makes the money—it’s thesittin’ and the waitin’ that makes the money.”This often has been incorrectly interpreted by many people to meanLivermore would buy a stock, and then sit and wait for it to move. Thisis not so. What he meant was there were many occasions when hesat and waited in cash, until the right situation appeared. When these47
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conditions came together, when as many of the odds as possible werein his favor, then and only then, like a cobra, he would strike, usuallywith great results.Buying on the Pivotal Point assured him the best chance of cominginto the situation just as the action was about to begin. And once he wassure of his play, he wasn’t afraid to make his commitment. He wasn’tcalled the Boy Plunger for nothing.It was Livermore’s ﬁrm conviction that when a speculator can determine the Pivotal Point of a stock and plan the action at that point, hemay make a commitment with the positive assurance of being right fromthe start.But bear in mind, when using Pivotal Points to anticipate movements, that if the stock does not perform as it should after crossingthe Pivotal Point, this is an important danger signal that must be heededimmediately. Every time Livermore lost patience and failed to awaitthe Pivotal Points, every time he ﬁddled around for easy proﬁts, helost money.The study of Pivotal Points is fascinating, providing a golden array ofopportunities for personal research. The trader can derive a singular pleasure and satisfaction from successful trades based on his own judgment.You will discover that proﬁts made in this way are immensely more gratifying than any that could possibly come from tips, or the guidance ofsomeone else. If you make your own discovery, trade your own way, exercise patience, and watch for the danger signals, you will ultimately beginthinking like a successful trader. The Pivotal Points theory applies to commodity trading as well as stock trading. Livermore never considered thistheory as a foolproof, perfect method of picking winners, but it does represent an essential part of the Livermore trading system. Pivotal Pointsare vital as the conﬁrming signal that your judgment is correct, but youmust let them play out.No trader is right all the time on the market. On occasion, the market will move contrary to what a speculator has predicted. At thesetimes, the successful speculator must abandon his predictions, and follow the market action. A prudent speculator never argues with the tape.Remember what Livermore preached: Markets are never wrong—opinions often are.The Crash of 1929 brought about Livermore’s complete belief inPivotal Points. Black Tuesday was the biggest Pivotal Point in the history of the stock market—the market fell 11.7 percent in one single day.This would represent a drop of 1100 points on the Dow in a single dayin today’s market.Livermore said that once he understood Pivotal Points they became
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one of the true trading keys, a reliable trading technique that was basically unknown, in a formal way, to stock speculators of the twenties andearly thirties and is to this day hardly used by traders. Pivotal Points area timing device that can be used to get in and out of the market withgreat success.The Reversal Pivotal Point is not easily deﬁned. In Livermore’s mind itwas “a change in basic market direction—the perfect psychological timein basic market direction—the perfect psychological time at the beginningof a new move, representing a major change in the basic trend.”For Livermore’s style of trading it did not matter if a stock was at thebottom or the top of a long-term trending move, because he would buy orsell any stock, going long or short at any time.The Reversal Pivotal Point ﬂagged the optimal trading timing for him.Figures 4.1 and 4.2 show the Reversal Pivotal Point.
Figure 4.1 This is the ﬁrst of two examples that show the Reversal PivotalPoint. For Yahoo! the Reversal Pivotal Point came in October.
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Figure 4.2 This is the second of two examples that show the Reversal PivotalPoint. For Merrill Lynch the Reversal Pivotal Point came in March.
Volume FactorsReversal Pivotal Points are almost always accompanied by a heavyincrease in volume, a climax of buying, which is met with a barrage ofselling—or vice-versa. Increased volume is an essential element in understanding Pivotal Points—it is usually present and conﬁrms the PivotalPoint. This battle between buyers and sellers causes the stock to reverseits direction, top out, or bottom out in a decline. In effect, it has changedmomentum and is at the start of a new trend direction for the stock. Lookfor the tell-tale increase in volume. These important conﬁrming volumespurts often end the day with a 50 percent to 500 percent increase in theaverage daily volume.Reversal Pivotal Points usually came after long-term trending moves.This is one of the reasons why Livermore always felt patience was so nec-
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essary for success in catching the big moves. You need patience to be surethat you have identiﬁed a true Reversal Pivotal Point. He developed thefollowing tests:First, he would send out a probe. He would buy a small percentageof the overall stock position that he wanted to eventually establish;if he was correct on the ﬁrst trade, he made a second trade. Thisstrategy is fully explained in the Money Management section of thisbook.He used a second test to conﬁrm whether a Reversal Pivotal Pointhad truly occurred. He employed his Top Down Trading Procedureand looked at the Industry Group, always looking at the two leadingstocks in the group, to see if they had the same pattern as the stockhe was interested in trading. This was the ﬁnal conﬁrmation heneeded to conﬁrm that he was on the right track. (See Figure 4.3.)
Figure 4.3 When Livermore employed his Top Down Trading Procedure, helooked at the industry group, and then he looked at the two leading stocks in thegroup, to see if they had the same pattern as the stock he was interested in trading.
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Figure 4.3 (Continued)
PIVOTAL POINT TRADINGEvaluating Continuation Pivotal PointsLivermore’s Pivotal Point methodology divided Pivotal Points into twocategories. The ﬁrst, which we have already discussed, he called a Reversal Pivotal Point; the second he named the Continuation Pivotal Point.It is essential to understand that while the Reversal Pivotal Pointmarks a deﬁnite change in direction, the Continuation Pivotal Point conﬁrms that the move is proceeding in the proper direction. ContinuationPivotal Points usually occur during a trending move as a natural reactionfor a stock in a deﬁnite trend. A pattern is forming that demonstrates support or resistance lines. The trader must wait as this formation builds todetermine if the pattern will develop into a support area. Or if the stockbreaks out on the downside, this may be the area of resistance line in thenext move upward.
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Figure 4.3 (Continued)
As has been stated so many times before in this book, never anticipate the market move, simply wait for the move to be revealed to youby the action of the stock. The Continuation Pivotal Point is a potentialadditional entry point in an ongoing move—it provides a signal, achance, to increase your position. Of course, the stock must emergefrom the Continuation Pivotal Point headed in the same direction itwas in before the correction. If not, this is a clear signal to close outyour position.Most importantly, Livermore deﬁned a Continuation Pivotal Point as aconsolidation in which the stock pauses and takes a breather in its ascent.It gives a stock a chance to consolidate, often allowing a stock’s ratio ofearnings and sales to catch up to its current price. It is usually a natural reaction in the stock’s progress. The prudent trader, however, will carefullyobserve which way the stock will emerge from this consolidation, and notanticipate. (See Figure 4.4.)
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Figure 4.4 The Continuation Pivotal Point is usually a natural reaction orpause in the stock’s progress. The prudent trader, however, will carefullyobserve which way the stock will emerge from this consolidation, andnot anticipate.
For Livermore, a stock’s price is never too high to buy or too lowto sell short. Waiting for these Continuation Pivotal Points signalsgave him the opportunity to either open a new position or to add toa current position. Do not chase a stock if it gets away from you—letit go.Livermore would rather wait and pay more, after the stock had regrouped and formed a new Continuation Pivotal Point, because this provides a conﬁrmation and mental insurance that the stock will most likelycontinue with its move.Conversely, this Pivotal Point theory can also uncover successfulshort-selling opportunities. Livermore looked for stocks that traded
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down to a new low for the last year or so. If they formed a False PivotalPoint, that is, if they rallied from this new low and then droppeddown through and formed another new low, they were most likely tocontinue down from there and establish additional new lows forthe move.By correctly catching either the Reversal Pivotal Points or the Continuation Pivotal Point, Livermore was able to make his initial purchase sothat he had an entry point at the right price from the beginning of themove. This ensured that he was never in a loss position and could therefore ride out the normal stock ﬂuctuations without risking his own capital. Once the stock had moved off the Pivotal Point Livermore was onlyrisking his paper proﬁts, not his actual capital, because he was “in proﬁt”from the beginning of the trade.His early years of getting crushed because he had bought the stock atthe wrong time in its move helped him formulate his unique theory of Pivotal Points. On many of those early trades he was “never in proﬁt.” If atrader buys before the Pivotal Point is established, he may be early. This isdangerous because the stock may never form a proper Pivotal Point to establish its direction clearly. But the trader must be careful—please notethat if you buy more than 5 percent to 10 percent above the initial Reversal Pivotal Point, you may be too late. You may have lost your trading edgebecause the move is already well underway.The Pivotal Point (either the Reversal or the Continuation point) isthe only tip-off you need to trade and win. A trader has to be patient, because it takes time for a stock to run its logical and natural course andform a proper Pivotal Point. (See Figures 4.5 and 4.6.) It will not be willedor forced forward by an impatient trader. It will come as a natural event.Be Patient!
Trade only on the Pivotal Points. I always made money when Iwas patient and traded on the Pivotal Points.—Jesse Livermore
Livermore also ﬁrmly believed that often the largest part of a stockmovement occurred in the last two weeks or so of the trade—he namedit the Final Mark-up Phase. The same thing applies for commodities. So,once again, a trader must be patient, get into position and wait, butat the same time he must be completely alert for the clues whenthey come, good or bad, and then take action to either buy or sellhis position.
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Figure 4.5 The Pivotal Point (either the reversal or the continuation point)gives the only tip-off you need to trade and win.
UNDERSTANDING TREND LINESAND PIVOTAL POINTSTrend lines are one of the oldest tools used by technical traders. They areeasily charted, readable, reliable and very useful. They easily can be employed in conjunction with the Livermore Theory. The key is to recognizewhether a line shows a true change in the basic trend of a stock or simplya normal reaction. (See Figures 4.7 and 4.8.)The trend lines are formed between the relative highs and the relativelows of a stock’s trading pattern. They form a channel within which thestock trades. This channel supplies the trader with a picture of the sup-
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Figure 4.6 Another chart showing the Pivotal Point. A trader has to be patient,because it takes time for a stock to run out its logical and natural course and forma proper Pivotal Point. It will not be willed or forced forward by an impatienttrader. It will come as a natural event.
port and resistance channel. Support is usually identiﬁed by a previous reaction low causing the stock to be supported at this old low. Resistance isthe opposite of support. It represents a price level or an area above themarket where selling pressure simply overpowers buying power and thestock is turned back or repelled at this level, retreating usually back intothe trough.Usually, when the trend lines are broken, the stock will continue totrade in the direction of the breakout. It should be noted that this can bein either direction. These trend lines can be formed and identiﬁed in alltime frames.
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Figure 4.7 The trend lines are formed between the relative highs and therelative lows of a stock’s trading pattern. Break-outs occur when the trend lineis broken.
In Figures 4.9 and 4.10, we are using 10 days, and a 6-month timeframe for the same stock. All these various time frames can be successfully traded. The volatility of the stock is in direct proportion to the timing—the shorter the time frame, say one day, the more volatile thestock movements.Because trend lines have been around forever and are very simpleto use, many traders do not spend a lot of time and energy on them.This was a mistake as far as Livermore was concerned because thetrend lines can give the trader a clear picture of the momentum behind a stock—up, down, or sideways, and they clearly deﬁne the channel within which a stock moves—this makes it far easier for the traderto see when the stock breaks out and when it breaks down—out of