Thursday, 5 November 2009

How to trade in stocks

John Mangun
Outside the Box
Business Mirror

One of the most interesting characters of the stock market history is Jesse Livermore. After making and losing several multimillion-dollar fortunes trading the market, Jesse committed suicide in 1940, not because he was broke; he had $5 million in the bank. He had simply lost his confidence in trading stocks. And this was a man who made $3 million in the crash of 1907 and $100 million in the famous crash of 1929.

Adding to the mystique of the man is that his only son, Jesse Jr., also committed suicide, by inhaling natural gas in 1976; his son, Jesse III, killed himself exactly the same way in 2006.

Livermore was the No.1 example of a trader, not an investor. The $3 million that he earned as profit in 1907 was lost in a series of brief trades in cotton.

His success in 1929 was the realization that there was not enough capital and liquidity in the US economic system and eventually that fact would catch up with the market and cause stock prices to fall. He successfully shorted the market prior to the crash. It was the same formula he had employed in 1907.

By 1934 he was broke again and he never regained his touch. In 1940 he wrote How to trade in stocks, a book that never found favor with market players because of his unusual and novel ideas. One quote probably says it all about stock trading and stock traders: “The game of speculation is the most uniformly fascinating game in the world. But it is not a game for the stupid, the mentally lazy, the person of inferior emotional balance, or the get-rich-quick adventurer. They will die poor.”

Reading Livermore is what first got me interested in technical analysis as a very young trader and then as a stockbroker. Livermore wrote, “All through time, people have basically acted and reacted the same way in the market as a result of: greed, fear, ignorance, and hope. That is why the numerical formations and patterns recur on a constant basis.” This thought is the foundation of technical analysis. The lessons that Livermore learned and the “trading rules” he practiced were finally popularized in the book Reminiscences of a stock operator by Edwin Lefevre in 1940; Lefevre is the front man for the book that Livermore probably wrote himself.

The most important fundamental of Livermore’s trading was to cut losses quickly. This is the most difficult of all trading habits to follow.

Cutting losses quickly is the No. 1 strategy that a trader must employ. Look at 2008. Those that bought, held, and hoped were wiped out. Rationalizing a losing position is the best way to go broke. I cannot overemphasize to my market update subscribers that a position that breaks below technical support should be sold and sold without ever looking back and without any regret.

Stocks will not always—maybe not even the majority of the time—go in the direction you want them to. But holding a losing position is like having a death wish. A falling stock that you own at a higher price may seem bad. But I guarantee you that tomorrow or next week or next month, you will wish you had sold it when it was only “bad” because eventually that position will become a losing nightmare.

Knowing at what point to cut a position can be found through technical analysis and the price supports that the charts show. Livermore called these “pivotal points.” Not only do these pivotal points show trends but they reflect momentum. Higher highs and higher lows as we having now on the long-term PSE Index charts are a solid indicator that a current uptrend is merely taking a slight pause for the moment.

Cutting losses quickly protects a losing position. However, profit-taking can be just as problematic. Although an
aggressive speculator, Livermore did not like losing. He never committed and traded all his funds at one time. He would buy a stock as it rose, putting more and more money into the stock as it went higher. Livermore was neither a “bottom fisher” nor a “bargain hunter.” I know my own advice is frustrating sometimes when I tell people to wait as they see an issue going higher and I have not suggested buying. You want to make sure the upward momentum is there before you make your major commitment of funds.

When should you take profits? Livermore did this: he liked taking one-half of his profit at a predetermined level and then let the balance of the position run. Once a stock has reached a resistance point, sell shares equal to some or all of your profit and leave your original investment amount in place. Or take your original investment out of the market and let the profit amount run.

Perhaps, most interesting to the average stock-market player is that Livermore believed that often the best issues were those that were making new historic highs. Our conventional wisdom tells us that a stock at the high is not a bargain. Yet, Livermore understood that when a trader buys at a new high, for that moment in time, the only holders are happy holders. Cloudless skies are above and there are no longer-term investors waiting to sell at the high just to break even. Buying at the high should not be discounted as a part of an overall strategy.

The final word on trading strategies perhaps best comes from George Soros: “It doesn’t matter how often you are right or wrong—it only matters how much you make when you are right versus how much you lose when you are wrong.”

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