Trading Lessons from Jesse Livermore

“Boy Wonder”, “Boy Plunger” and the “Great Bear of Wall St.” are a few of the monikers Jesse Livermore was known by.

Livermore was immortalized in the trading classic Reminiscences of a Stock Operator by Edwin Lefevre — a book your author has read countless times over the years and still pulls new wisdom from with each revisit.

Reminiscences has stood the test of time because it, more than any other book, explains the fundamental truths that lie at the heart of successful speculation. It’s no doubt a reflection of Livermore’s deep and intimate understanding of this great game.

One of the ironies I’ve learned through years of dissecting the habits and practices of top traders like Livermore is that there is nothing special to what they do. I’m not implying that what they’re able to do isn’t impressive; of course it is. I simply mean that they have no special or secret knowledge or ability that’s unique to them.

Most people start out in this game looking for that “thing”; whether it be a special insight or indicator or strategy or whatever, that will show them how to win. They think if they can just find the secrets to what make the greats great, then they’ll be set. But in reality… if there’s any secret at all, it’s that there is no secret.

All of the important truths that a speculator needs to understand were plainly communicated by Livermore over 75 years ago.

Does that mean you can read Reminiscences… and instantly become a great trader? Well, let me ask you this: can you read the classic Ben Hogan’s Five Lessons on golf and go out and play scratch golf? Of course not! And that’s because both books have all the foundational knowledge you need to succeed but they don’t supply the practice that ingrains the lessons and transforms that knowledge into wisdom.

Here’s how Livermore put it, “The training of a stock trader is like a medical education. The physician has to spend long years learning anatomy, physiology, materia medica and collateral subjects by the dozen. He learns the theory and then proceeds to devote his life to the practice.”

The practice is the hard part. It takes time and a Herculean effort. Blisters and portfolio losses. There are no short-cuts. But practice without knowledge is wasted effort. It’s like trying to run on your hands because nobody ever told you to use your feet.

So with that, here’s the knowledge (with some commentary by me), as given by Livermore many years ago. What you do with it is up to you but I suggest you try running with your feet.

Learn How to Lose

An old broker once said to me: ‘If I am walking along a railroad track and I see a train coming toward me at sixty miles an hour, do I keep on walking on the ties? Friend, I sidestep. And I do not even pat myself on the back for being so wise and prudent.’

To be a great trader you have to be a great loser. Sounds like a contradiction right? Well it isn’t. The fact is, great traders will typically have more losing trades than profitable ones. They’ll spend more time in an equity drawdown than at new highs. Some of this is due to the natural 90/10 distributions of markets (Pareto’s Law), but much of it is actually by design.

Mark Spitznagel wrote in The Dao of Capital that the most valuable lesson he learned from his Chicago trading pit mentor, Everett Klipp, was that “you’ve got to love to lose money.” If you love to take small losses then you’ll never take a large one. That’s important because it’s the large ones that’ll kill ya’.

Humans are naturally averse to losing (obvious statement). Our psychological programming attaches a lot of nonsensical meaning to taking losses in the market. We are evolutionarily wired to be bad emotional traders. The key is to invert this instinctual response and learn to “love to lose”. Livermore talks about this inversion:

Losing money is the least of my troubles. A loss never bothers me after I take it. I forget it overnight. But being wrong — not taking the loss — that is what does damage to the pocketbook and to the soul.

And here’s a simple and yet KEY… KEY… fundamental truth to good trading: never add to your losers, sell what shows you a loss, and let run what shows you a profit.

Of all speculative blunders there are few worse than trying to average a losing game. My cotton deal proved it to the hilt a little later. Always sell what shows you a loss and keep what shows you a profit. That was so obviously the wise thing to do and was so well known to me that even now I marvel at myself for doing the reverse.

This lesson was important enough that Paul Tudor Jones had it plastered on the wall right above his desk.

Livermore’s occasional failure to follow this rule is what led to the multiple blowups he experienced throughout his career. He lost when he failed to follow his advice that it’s “foolhardy to make a second trade, if your first trade shows you a loss. Never average losses. Let this thought be written indelibly upon your mind.”

Livermore learned the hard way that our natural instincts must be flipped.

Instead of hoping he must fear and instead of fearing he must hope. He must fear that his loss may develop into a much bigger loss, and hope that his profit may become a big profit.

The Importance of Understanding General Conditions

I still had much to learn but I knew what to do. No more floundering, no more half-right methods. Tape reading was an important part of the game; so was beginning at the right time; so was sticking to your position. But my greatest discovery was that a man must study general conditions, to size them so as to be able to anticipate probabilities.

Not many people realize this, but Livermore was the original “global macro” guy. His “greatest discovery” was the importance of macro — or what he called “general conditions”.

He had the same realization that hedge fund manager Steve Cohen had decades later, which is “that 40 percent of a stock’s price movement is due to the market, 30 percent to the sector, and only 30 percent to the stock itself.”

After Livermore made this discovery he said “I began to think of basic conditions instead of individual stocks. I promoted myself to a higher grade in the hard school of speculation. It was a long and difficult step to take.”

This revelation completely changed the way he approached markets and trading. While everybody was piking around, losing money playing the “stock picking” game, Livermore was studying general conditions. He now understood the simple fundamental truth that you want to be long in a bull market and short in a bear market.

I think it was a long step forward in my trading education when I realized at last that when old Mr. Partridge kept on telling the other customers, ‘Well, you know this is a bull market!’ he really meant to tell them that the big money was not in the individual fluctuations but in the main movements — that is, not in reading the tape but in sizing up the entire market and its trend.

Disregarding the big swing and trying to jump in and out was fatal to me. Nobody can catch all the fluctuations. In a bull market your game is to buy and hold until you believe that the bull market is near its end. To do this you must study general conditions and not tips or special factors affecting individual stocks.

It’s when Livermore started playing the macro game that he really started making the big money.

I cleared about three million dollars in 1916 by being bullish as long as the bull market lasted and then by being bearish when the bear market started. As I said before, a man does not have to marry one side of the market till death do them part.

But I can tell you after the market began to go my way I felt for the first time in my life that I had allies — the strongest and truest in the world: underlying conditions. They were helping me with all their might. Perhaps they were a trifle slow at times in bringing up the reserves, but they were dependable, provided I did not get too impatient.

General conditions (macro) continue to be — BY FAR — the biggest potential source for alpha in trading. That’s because most market participants are still focused on the stock picking game and remain completely ignorant of the most significant driver of their stock’s price action. Learning to read the underlying conditions is like swinging the trading equivalent of Thor’s Hammer… it makes that much of a difference.

Patience, Psychology and the Dangers of Overtrading

It sounds very easy to say that all you have to do is to watch the tape, establish your resistance points and be ready to trade along the line of least resistance as soon as you have determined it. But in actual practice a man has to guard against many things, and most of all against himself — that is, against human nature.

Livermore understood man’s foibles perhaps better than most. He made and lost multiple fortunes, the size of which, most could hardly fathom. He knew well the fundamental truth that becoming a great trader is as much about self-mastery as it is about market mastery.

Market Wizard Ed Seykota said “I think that if people look deeply enough into their trading patterns, they find that, on balance, including all their goals, they are really getting what they want, even though they may not understand it or want to admit it.”

True professional speculation is often a tedious and boring affair, where one can go months without putting on a trade because the general conditions are not right.

There is a time for all things, but I didn’t know it. And that is precisely what beats so many men in Wall Street who are very far from being in the main sucker class.

Most traders that I see are not really in the game to make money by strictly following a sound trading process. They want quick profits; the thrill of gambling; high adrenaline entertainment. Basically the same lizard brain “wants” that drive the large profits for Vegas casinos.

This is why most people overtrade. And they overtrade a lot. Here’s Livermore’s thoughts on why that’s bad.

There is the plain fool, who does the wrong thing at all times everywhere, but there is the Wall Street fool, who thinks he must trade all the time. No man can always have adequate reasons for buying or selling stocks daily–or sufficient knowledge to make his play an intelligent play.

The overtrading by others brings us to another fundamental truth: that other’s impatience can be our profits if we’re willing to practice infinite patience.

The desire for constant action irrespective of underlying conditions is responsible for many losses on Wall Street even among the professionals, who feel that they must take home some money every day, as though they were working for regular wages. Remember this: When you are doing nothing, those speculators who feel they must trade day in and day out, are laying the foundation for your next venture. You will reap benefits from their mistakes.

When putting on a trade it’s better to be a little late than a little early. As Livermore put it, “don’t take action with a trade until the market, itself, confirms your opinion. Being a little late in a trade is insurance that your opinion is correct. In other words, don’t be an impatient trader.”

Self-mastery leads to market mastery. Livermore said “the human side of every person is the greatest enemy of the average investor or speculator. Fear keeps you from making as much money as you ought to. Wishful thinking must be banished.”

Price Action and Path of Least Resistance

There is what I call the behavior of a stock, actions that enable you to judge whether or not it is going to proceed in accordance with the precedents that your observation has noted. If a stock doesn’t act right don’t touch it; because, being unable to tell precisely what is wrong, you cannot tell which way it is going. No diagnosis, no prognosis. No prognosis, no profit.

Livermore was one of the best at reading the tape. His years of studying price action gave him a sort of “sixth sense” for knowing what the market was doing and where it was headed. This is one of those “practice” elements where only so much instruction can be given… the rest needs to be learned and experienced.

But one of the important lessons that Livermore talked about is studying price action in order to determine the “path of least resistance”, saying:

For purposes of easy explanation we will say that prices, like everything else, move along the line of least resistance. They will do whatever comes easiest, therefore they will go up if there is less resistance to an advance than to a decline; and vice versa.

The path of least resistance is all about understanding accumulation/distribution or consolidation/expansion zones. A chart is simply a two dimensional representation of supply/demand. The path of least resistance is the price level that supply/demand is likely to move towards based off past and current accumulation/distribution levels.

Learn to read supply and demand action with practice and your trading will become more fluid. Livermore stated, “It would not be so difficult to make money if a trader always stuck to his speculative guns — that is, waited for the line of least resistance to define itself and began buying only when the tape said up or selling only when it said down.”

A critical part to what he’s saying is to wait for the path of least resistance to present itself. Attempting to anticipate trend changes is a costly and foolish endeavor.

One of the most helpful things that anybody can learn is to give up trying to catch the last eighth — or the first. These two are the most expensive eighths in the world. They have cost stock traders, in the aggregate, enough millions of dollars to build a concrete highway across the continent.

Trend reversals are a process, not an event. Livermore notes “that a market does not culminate in one grand blaze of glory. Neither does it end with a sudden reversal of form. A market can and does often cease to be a bull market long before prices generally begin to break.”

The trend is your friend and there are separate trends on different time intervals. The more trends that line up on each interval, the lesser resistance on the trade’s path.

Big Bets and Sitting Tight

And right here let me say one thing: After spending many years in Wall Street and after making and losing millions of dollars I want to tell you this: It never was my thinking that made the big money for me. It was always my sitting. Got that? My sitting tight!

Men who can both be right and sit tight are uncommon. I found it one of the hardest things to learn. But it is only after a stock operator has firmly grasped this that he can make big money.

The average trader is quick to take a profit and slow to book a loss. Going back to the importance of inverting our trading nature, it’s as important to let profits run as it is to cut losses short. Remember, we’ll lose more than we’ll be right. So we need those winners to be significantly larger to pay for our losers. Livermore said, “they say you never grow poor taking profits. No, you don’t. But neither do you grow rich taking a four point profit in a bull market.”

Livermore explained successful trading plainly, “I study because my business is to trade. The moment the tape told me that I was on the right track my business duty was to increase my line. I did. That is all there is to it.”

The fundamental truths of speculation, as laid out by Livermore three quarters of a century ago, can be summarized as follows:

• Cut your losses: Never average down and never hope losses reverse. Just cut.
• Infinite patience: Good trades are few and far between. Trade for profits, not for action.
• Learn macro: Understanding general conditions is essential to being a market master and not a piker.
• Price action is king: Learn to read the tape and don’t argue with markets — they know more than you.
• Big bet/sit tight: Ride your winners for all their worth. This conviction comes with practice.
• Self-mastery: You are your greatest impediment to your own success. “Know thyself”.

These lessons are as true today as they were then. As Livermore put it, “there is nothing new in Wall Street. There can’t be because speculation is as old as the hills. Whatever happens in the stock market today has happened before and will happen again.”

One just needs to look to Stanley Druckenmiller — perhaps the closest modern day equivalent to Jesse Livermore — to see that these truths still hold true. Here’s Druck:

The first thing I heard when I got in the business, not from my mentor, was bulls make money, bears make money, and pigs get slaughtered. I’m here to tell you I was a pig. And I strongly believe the only way to make long-term returns in our business that are superior is by being a pig. I think diversification and all the stuff they’re teaching at business school today is probably the most misguided concept everywhere. And if you look at all the great investors that are as different as Warren Buffett, Carl Icahn, Ken Langone, they tend to be very, very concentrated bets. They see something, they bet it, and they bet the ranch on it. And that’s kind of the way my philosophy evolved, which was if you see – only maybe one or two times a year do you see something that really, really excites you… The mistake I’d say 98% of money managers and individuals make is they feel like they got to be playing in a bunch of stuff. And if you really see it, put all your eggs in one basket and then watch the basket very carefully.

Livermore said that “A man can have great mathematical ability and an unusual power of accurate observation

and yet fail in speculation unless he also possesses the experience and the memory. And then, like the physician who keeps up with the advances of science, the wise trader never ceases to study general conditions, to keep track of developments everywhere that are likely to affect or influence the course of the various markets.”

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