The Investing Style of Jesse Livermore
The Life of Jesse Livermore
Jesse Livermore was born in 1877 and died in 1940. He was a wealthy flamboyant character who was renowned for making multi-million dollar fortunes and then losing a large portion of his wealth which he did several times over.
Jesse Livermore was known as the "Great Bear of Wall Street" who shorted the market crashes of 1907 and 1929 where he mostly made his fortunes.
Jesse Livermore was a self taught stock trader and commodities trader utilizing his own investing style and approached the markets with the attitude of a businessman operating a business.
He lived the life style of the rich and famous and lived in a mansion, owned a yacht and even owned a private railway car fully furnished.
The amazing life of Jesse Livermore begins in Massachusetts where he was raised on a farm.
At the age of 14 Jesse realized this was not the life for him and he ran away from home. He ended up in Boston where he worked for a brokerage firm posting stock quotes.
This gave Jesse an inside view of the operations of the stock market which he used to his advantage.
At the age of 15 he started betting on stock price movements through the bucket shops (which were a form of betting over stocks as opposed to actually buying stocks through a broker).
Jesse Livermore had a natural talent for picking the right stocks to bet on and was a rationally thinking trader even at the age of 15.
Jesse Livermore profits accumulated and by the age of 20 was already becoming quite wealthy.
He was subsequently banned from most of the bucket shops as he was winning too much money. The money Jesse was making was the money the bucket shops were losing as they operated as a betting agency.
Jesse Livermore then moved to New York City and was now trading on actual stock and commodities markets. Jesse Livermore married the first of his three wives at the age of 23 in 1900 and during this time his trading turned for the worst and he lost his accumulated wealth.
Jesse Livermore slowly re-accumulated his wealth and became famous after the crash of 1907 where he short sold the market and reportedly was now worth $3 million (that's in 1907 dollars).
It was Jesse Livermore's investing that attracted the attention of Wall Street as he had his own unique style of trading for his day. Brokerage firms were not used to customers withdrawing profits from their accounts as most speculators of the time were forced to deposit additional funds to meet margin calls.
It was Jesse Livermore’s unique investing style
that attracted the attention of Wall Street
In 1917, Jesse and his wife Nettie divorced. He then married Dorothy and they had two sons named Jesse Jr. and Paul.
Jesse Livermore correctly called the market crash of 1929 and short sold. His worth was now reported to be $100 million dollars (which is several billion dollars in today's money).
In 1932, Jesse and his second wife Dorothy divorced with Dorothy retaining custody of their two boys. In 1933 Jesse married Harriet his third wife.
In 1934, Jesse Livermore once again managed to lose the fortune he accumulated through the market crash of 1929.
Jesse Livermore struggled from here on and never managed to recoup his previous fortune even though he was still relatively wealthy compared to most people during the great depression.
His son Jesse Jr. suggested in 1939 that Jesse Livermore write a book about the trading tactics he used in the stock and commodities markets.
The book was titled How to Trade in Stocks and was published in 1940 during World War II, however interest in financial markets was low during this period and his book was not well received.
Jesse was suffering from clinical depression and in 1940 he committed suicide tragically ending his life. At the time of his death Jesse Livermore's wealth was reported to be $5 million.
The Investing Style of Jesse Livermore
" There is only one side of the market and it is not the bull side or the bear side, but the right side." Quote by Jesse Livermore
The Early Days
During the early 1900s, in the days of Jesse Livermore, investing was a term used to describe an income producing asset and thus corporate bonds were considered an investment.
Stocks, with the exception of some large blue-chip corporations and utility companies, mostly did not pay dividends and as such buying stocks was considered speculation rather than investing.
Jesse Livermore's investing style is best summed up as speculative trading. Jesse based his trading decisions largely on the price action of the stock or commodity he was trading and utilized strict money management rules.
This approach was radical in his days as most stock purchases were based on nothing more than tips and rumors and fundamental analysis for the most part did not exist.
Studying the price action was a difficult task without computer technology and very few bothered with it.
A notable exception was Charles Dow and his successor Peter Hamilton who published numerous articles dealing with the price movement of the Dow Averages.
Jesse Livermore is more widely known for trading stocks but he was also an active commodities trader.
While Jesse Livermore never used price charts (as they needed to be plotted by hand in Jesse's days) his trading techniques bear a remarkably strong resemblance to modern day technical trading techniques such as position trading.
Unlike modern day technical traders who focus exclusively on the information contained on a stock chart, Jesse Livermore traded more like a modern day speculator by incorporating market conditions, industry conditions and stock leadership into his trading strategy.
He was also fully aware of the current economic conditions and had a sound understanding of economics.
He also had a through understanding of industries and the leading companies in their industry.
Top Down Trading
Rather than simply finding a stock to trade, Jesse Livermore first determined the market conditions, then the industry conditions and finally the stock leadership and would also locate a sister stock.
Top Down Trading:
- The Market: Jesse Livermore would first determine the current market direction which he called the "Line of Least Resistance". Jesse never used the terms Bull or Bear, but basically if the line of least resistance is upwards, Jesse would look for long sided trades and if the line of least resistance was down then Jesse would look for short sales. Nowadays it's referred to as trading with the market. Jesse traded NYSE listed stocks.
- The Industry Group: Jesse Livermore would then check the industry groups. If the market was trading upwards, Jesse would look for a strong industry group which was also moving upwards and look for the strongest stock in that industry group. Jesse was also a notorious short seller and would look for weak industries for the weakest stock when the line of least resistance for the market was down.
- The Sister Stock: Jesse Livermore always looked for a sister stock for comparison with the stock he was trading. This in essence is similar to Dow Theory which uses two different Averages for conformation. The sister stock is a direct competitor and Jesse reasoned that if the sister stock was showing signs of reversing then the stock he was trading might follow even if it was not currently showing any signs. Jesse Livermore watched the price action of both the stock he was trading and the sister stock very carefully.
Jesse Livermore's view was that understanding industry group action was essential to successful trading. Jesse never rushed or forced an entry.
A quote from Jesse Livermore reads "Wait until the Preponderance of Evidence is in your Favor, Use Top Down Trading and be patient".
The group movement premise was quite simple to Jesse Livermore. If the basic reasons are sound for a particular stock in an industry to come into favor, the rest of the stocks in that industry should follow for the same basic reasons.
For Jesse this also worked on the short side. When an industry goes out of favor then all stocks in that group go out of favor.
Jesse Livermore also stated that the only exception to this group behavior was when a single stock was significantly large that it created its own industry movement.
The Current Leaders
Jesse Livermore predominantly traded the industry leaders rather than the small-cap stocks. This had a lot to do with the times as there was no computerized screening available.
Any proposed stocks had to be manually tracked and Jesse felt more comfortable tracking the leaders rather than the minor issues.
Jesse Livermore predominantly traded the industry
leaders rather than the small-cap stocks
Jesse never used high stock prices as a signal to sell a stock as his reasoning was that a leader can go on to much higher prices. He was one for buying new highs and short selling new lows which was a contrarian point of view in his day.
His line of reasoning was that if the minor issues were still following the leader then the leader still had further to rally for a long sided trade or conversely had further to sell for a short sided trade.
Jesse Livermore also noted that the leader in an industry group is not necessarily the largest company.
The leader he defined as a significant company which was the first to make its move. He reasoned that the first to make its move would be the stock to continue to make its move.
He also noted that the leader changed with each subsequent bull market.
He also called the tops of markets by noting that the as strongest industry groups began collapsing it was a signal that the market overall may be heading for a correction.
Reversal Pivotal Points
Reversal pivotal points as Jesse Livermore called them are the tops and bottoms of major moves. These pivotal points are usually referred to as Relative highs and lows nowadays.
Jesse used these reversal pivotal points to note the market direction and the direction of the industries he was tracking. Jesse also used these to determine when an individual stock was ready to make its move.
Jesse Livermore was an extremely patient stock trader and had stated that it was his sitting and waiting that made him his money.
For Jesse to take a trade he would wait for the reversal pivotal point to confirm a stock's new uptrend direction and he would buy a small test parcel of shares which he called a probe.
As the stock continued higher he would progressively buy more parcels of shares. That is, Jesse pyramided into his position at successively higher prices and this was one of his money management rules.
Jesse Livermore rigorously used stop-loss exits if the stock price moved contrary to his expectation. He was adamant that markets are never wrong but opinions often are.
Jesse noted that if he was wrong then he had only a small position to dispose off, but if he was right then his small position did not trigger an exit and a new uptrend had begun from which he would pyramid into.
Compared to modern day technical traders with trades only lasting for days or weeks, Jesse Livermore was a long-term stock speculative trader with trades lasting up to several years.
Jesse was after the big moves and did not care about the short-term noise.
Continual Pivotal Points
A continual pivotal point for Jesse Livermore is basically a pullback in an up-trending stock or a rally in a downtrend.
He used these continual pivotal points as confirmation that the uptrend was progressing and would buy more shares each time the stock price traded above the Relative High of the pullback.
Jesse Livermore only ever added to his positions at new Relative Highs. He also applied the same principle to short selling and would only short sell when the stock price dropped below the Relative Low of a minor rally.
As a general rule Jesse was cautious about how high above the pivotal point the confirmation was. He preferred 5% to 10% from the continual pivotal point low to the relative high.
Jesse Livermore carefully studied the price and volume nature. Jesse was wary of price spikes which he classified as an abnormal price increase over several days accompanied by abnormally high volume of a least fifty-percent increase over the normal volume.
Jesse called this an aberration which to him was any price and/or volume action that deviates from the norm. He considered aberrations a danger signal and would often exit the trade.
Downward Spikes for short side trades were also considered aberrations for Jesse and he would often use this as a signal to exit his short positions.
Breakout to a New High
New highs formed the basis for Jesse Livermore to add to his position. To Jesse, breakouts from consolidation were positive events as this indicated the stock had further to climb.
Jesse Livermore did not anticipate the breakout but rather waited for the price to actually make its new high.
He never tried to figure out why the stock would breakout, but simply followed the price and volume action.
Jesse was wary of breakouts on heavy volume that did not lead to a strong continuation. He considered this a warning that the stock may have topped out.
He used the same breakout principle for the short side with the stock breaking down out of consolidation. He expected the stock to make a strong move downwards.
Jesse liked to exit a portion of his position on strong moves and would often exit his entire position on moves which were significantly stronger than the norm.
Jesse's Money Management Rules
" A prudent speculator never argues with the tape. Markets are never wrong, opinions often are." Quote by Jesse Livermore
Jesse's Trading Style
The Probe Trade and Pyramiding
Jesse Livermore always pyramided into his positions at continuously higher prices.
His first position he called a Probe which was basically a test trade. If Jesse was after a total position of 1000 shares he would conduct a test trade of say 200 shares.
If the stock triggered his stop-loss level then all he would lose was the loss on a 200 share position. If the stock continued upwards he would add another 200 shares.
He would continue this until he reached his total shares target.
He would normally split his total share position into three to five pyramiding positions with the last position being no more than 5% to 10% above the pivotal point.
Jesse's reasoning for buying each subsequent position at higher prices was that each 200 share position must show an open profit before he would add another position.
Jesse based the decision on how to break up the total position on personal experience and would adjust the breakup according to the personality of the stock or commodity he was trading.
Jesse Livermore used a price percentage stop-loss where he would exit if his view was wrong. He called it his bucket shop rule where he used a 10% stop to exit his trade.
This was because of the 10% margin that was used when he traded through the bucket shops.
Using a stop-loss was radical in Jesse's days as no one really used stops in those days.
Jesse Livermore was an early pioneer being one
of the first to use the stop-loss technique
Jesse was a master at sensing when a stock was not behaving as he was expecting and would often sell before the stock or commodity would decline by 10%.
He based his rule on the notion that the most he was prepared to lose on any one trade was 10%.
Speculators' meeting a margin call by supplying additional funds was common practice in Jesse's days. Jesse Livermore would never meet a margin call and if it came to that he would simply exit his trade.
In those days it was normal for speculators to hold onto their losing positions in the hope that prices would return so that they can exit breakeven.
This included stocks bought on margin. Jesse referred to these speculators as involuntary investors.
One of Jesse Livermore's tactics was to only trade the best opportunities and spend the rest of the time sitting on the sidelines.
Jesse used playing poker as an analogy and did not believe in playing every hand. Unless he was confident he was going to make money he did not participate.
To Jesse Livermore, the preservation of trading capital was of prime importance.
He reasoned that if the speculator were to continuously trade with the marginal opportunities, then all that will end up happening is that their cumulative losses will deplete their trading account and when a good opportunity came along there would be insufficient capital left to make the trade.
Jesse Livermore was a firm believer in patience and having a reserve cash balance.
Let the Winners Ride
Jesse Livermore was essentially a speculative trader compared to today's short-term traders such as swing traders and position traders. So long as the stock or commodity was behaving correctly, then he had an open profit and would let it ride.
He would only exit if the stock or commodities behavior deviated from its normal action.
Jesse reasoned that an open profit was just that, it is not locked in until all the positions taken are closed-out. He was willing to play with open profit and reasoned that if he lost this then what he lost was profit he never had in the first place.
He called open profits "the stock markets money" and basically only cared about closed-out profits as to him this was real profit - money in the bank.
Jesse's rule was to stick with a winner and let it ride until he had a good reason to exit the trade.
When he exited a trade at a significant profit, Jesse would withdraw 50% of that profit from his trading account. This to Jesse was his pay check.