In How to Trade in Stocks, Jesse Livermore wrote:

I have warned against averaging losses. That is a most common practice. Great numbers of people will buy a stock, let us say at 50, and two or three days later if they can buy it at 47 they are seized with the urge to average down by buying another hundred shares, making a price of 48.5 on all.

Having bought at 50 and being concerned over a three-point loss on a hundred shares, what rhyme or reason is there in adding another hundred shares and having the worry double when the price hits 44? At that point there would be a $600 loss on the first hundred shares and a $300 loss on the second hundred shares.

If one is to apply such an unsound principle, he should keep on averaging by buying two hundred shares at 44, then four hundred at 41, eight hundred at 38, sixteen hundred at 35, thirty-two hundred at 32, sixty-four hundred at 29 and so on.

How many speculators could stand such pressure?

So, at the risk of repetition and preaching, let me urge you to avoid averaging down… Why send good money after bad? Keep that good money for another day. Risk it on something more attractive than an obviously losing deal.

Pyramiding

In practice, Jesse Livermore would have traded with the trend, against the “suckers” averaging down. Since the stock price was falling, he would have sold it short and, as the price continued to fall, he would have pyramided his position. Every time the market moved in his favor, he would have bought a larger number of shares than he had bought the previous time. His gains would be identical to the losses incurred by someone who was averaging down.

People sometimes make the mistake of believing that Jesse Livermore was a purely technical trader.

It’s true that Jesse would try to exploit the market using his technically based tape-reading skills and it’s also true he wouldn’t worry too much about the reasons behind the numbers on the tape.

At other times though – as he explained in Reminiscences of a Stock Operator - he would act on his understanding of the fundamental economics of a situation.

The United State World Trade Corporation operated around the world. It owned shipping lines, coffee plantations in Guatemala, hydroelectric plants in Bolivia, banks in Peru and conducted a huge export business. In a bear market, the public remembered that USWT’s business was spread all over the world and so could divide its risks. The company continued to pay its quarterly dividend.

The bear market developed with severe declines. USWT stock descended in a leisurely manner. One day when the rest of the market showed an improvement, USWT stock suddenly fell five points on the highest volume in months.

USWT’s president and directors assured the public and the press that nothing was wrong and denied rumors that the dividend would be cut.

Instead of rallying, however, the stock fell further the next day and continued falling.

Then, to a chorus of outrage, the directors announced that there would be no quarterly dividend.

Why did USWT suddenly fall?

Jesse Livermore had been analyzing the export trade and conditions in South America and the Far East and had concluded that the economic conditions were not favorable and were going to worsen.

He looked for the stock that would corroborate and justify his opinion of basic conditions. There was USWT, whose price was falling, but had not been as badly sold down as many other stocks.

He got USWT’s annual reports for three years and then, when he understood the company’s finances as well as the underlying conditions in every one of the company’s lines of business, he sold short ten thousand shares of the stock.

He began at 110. The next morning, he read the president’s statement:

“I’ll tell you that there has been no talk whatever about it, and no desire or intention of either reducing or passing the next dividend. I hope we may never have to do that.”

This had the effect of making Livermore sell another ten thousand shares short, and the price broke so badly that he was encouraged to put out an additional short line of ten thousand shares on the third day.

Now the share price had fallen to the 80s. There was no inside support to speak of, and the room-traders on the floor saw it and sold so recklessly that the stock had a good rally on their covering.

Then came the last grand drive, at the opening, on the day after the directors’ meeting. Livermore took advantage of the big collapse to cover his shorts at a little above 60. He commented:

“I made a killing on that stock. I didn’t need any inside tip.”

Edwin Lefevre said to Livermore:

“And the beauty of it is that Wall Street accused the directors of speculating in their own shares. Do you remember the shriek the newspapers let out when the stock broke after the president came out with a statement that they were not going to pass the dividend? They did not know it was your selling. I happen to know that the decision to pass the dividend was not reached by the directors until two minutes before they took a vote on it.”

“Well,” said Livermore, “I reached it for them two weeks before they voted… I knew they must [pass the dividend]. I knew they must; if not this time, three months later.”

George Taylor emailed me asking why I don’t share the complete details of my personal trading methods. While I’m more than happy to talk about the general principles of how to trade and how Jesse Livermore’s view of trading can still be used as the basis of a trading system today, I won’t share specific details of my own techniques. Here’s why:

If you have a trading system that gives you an edge, you don’t go sharing it - not if you want to keep using it profitably. Think of it this way:

Imagine you discovered that at 4 a.m. each morning 100 gold coins would magically appear, scattered over a local beach. Getting up in the middle of the night is a pain but for 100 gold coins – well it’s good money. After a few days, in a generous mood, you share your secret with your best friend. Next morning at 4 a.m., you’ve got company on the beach. Your friend is there too – following an identical strategy to yours, gathering up the coins. From now on, you’re averaging only 50 coins a night.

Things go from bad to worse. Your friend tells his brother and his brother tells his uncle about the coins. Now you’re averaging 25 coins a night. Before too long, over 100 people know about the beach and then thousands have learned the secret. People are now making more money from selling books about gold coins on the beach than they are from actually going to the beach.

Arriving on the beach at 4 a.m. is no longer a useful strategy. It costs you more getting to the beach than you’ll be able to take in profit.

I hope that helps.

As its price rises to fresh heights I’m going to return to the topic of oil.

At the beginning of July 2007 I wrote about how I had profited from my long-term view of oil prices and I mentioned three stocks I got into several years ago. As of July 2007, the Canadian Oil Sands Trust (COS-UN.TO) had quadrupled in price in five years, Suncor (SU) had quintupled and UTS Energy (UTS.TO) had sextupled.

So, since then, what has happened to the prices of these stocks?

COS-UN.TO from 32.94 to 48.18 …………..up 46.3%

UTS.TO from 6.06 to 5.45 …………..down 10.0%

SU from 89.92 to 120.44 …………..up 33.9%

In ten months the average rise has been 23.4% (equal weighting) giving an annualized return of 27.5% - which is pretty good.

It would have been a lot better if I’d ditched UTS.TO last year, when it looked like the long-term uptrend was over. I was very patient with UTS.TO though because of my bullish view of oil in general, but it’s time to call it a day. I have now culled UTS.TO because its chart has been moribund for a couple of years. I’ll keep my eye on the other two stocks because the long-term slope of the uptrend has reduced in the last couple of years and it may be time to reassess how I should try to profit from oil in the long term.

I say this especially because I got into these stocks because I thought their price would rise faster than the price of oil. In the past year, however, the price of oil has doubled and the stocks haven’t kept pace.

Today’s Oil News

Goldman Sachs has predicted that oil could rise to $150 to $200 within two years as a result of demand rising faster than supply. (Others disagree.)

Why I Agree with Goldman Sachs and why Hillary Clinton won’t increase anyone’s Oil Production

I tend to avoid politics but I noted Hillary Clinton saying yesterday that she was going to use anti-trust legislation to force the OPEC cartel to pump more oil and bring the price down. Okay, yes, it’s a “political promise” - most of which are worthless - but I’ll use it to make my own point.

My question for Hillary Clinton is: why not use anti-trust legislation to force Texas to quadruple its oil output? Surely that would be easier to enact? The trouble is, of course, that Texas is running out of oil and governments can’t legislate for the magical creation of new oil. (Although the Fed seems to be doing it all the time with money!)

Just as Texas produces less oil than it used to, so does Saudi Arabia, the world’s biggest producer. Saudi Arabian oil production has almost certainly passed its peak. Hillary, you can’t force a country to pump oil it doesn’t have using anti-trust legislation.

Once we are aware of the initial velocity of an object we can accurately predict its entire journey. We use these principles to send spaceships to other planets. Similarly with oil, once we have the first few years’ of production data from a single oil field, or from a country’s oil fields or indeed a planet’s oil fields we can predict the entire trajectory of oil production. This is the basis of the famous Hubbert Curve and Peak. (Google it if you’re one of the few not yet familiar with it.)

This is the heart of the problem. The world’s population continues to rise. Industrialisation of the huge population centers of China and India continues apace. And – just like Texas produces less oil than it used to - so will planet Earth. It may be we’ve reached the peak. It may be the peak is still a year or two away.

Where will the price of oil go? In the short term, I don’t know. As traders we know that when a price trends upward, more people buy for technical reasons – trend followers, momentum traders, chartists - technical analysts of all persuasions. It’s difficult to say how much of today’s price is driven by speculation.

I’m happy to trade on the long-term trend without worrying massively about the fundamentals.

When I consider the fundamentals, the only thing I see that can bring the long-term price of oil down is reduced demand relative to supply; but I don’t see many signs of this happening.

Following on from my post I Was Right But My Timing Was Wrong, here are some of Jesse Livermore’s thoughts, From How To Trade In Stocks.

Jesse describes how he missed a one million-dollar profit through impatience. He also repeatedly broke his own trading rules and, as a result, lost $200,000.

(Bold sub-titles are mine.)

Strongly Bullish
Many years ago I became strongly bullish on cotton. I had formed a definite opinion that cotton was in for a big rise. But as frequently happens the market itself was not ready to start. No sooner had I reached my conclusion, however, than I had to poke my nose into cotton.

Initial Play
My initial play was for 20,000 bales, purchased at the market. This order ran the dull market up fifteen points. Then, after my last 100 bales had been bought, the market proceeded to slip back in twenty-four hours to the price at which it had been selling when I started buying. There it slept for a number of days. Finally, in disgust, I sold out, taking a loss of around $30,000, including commissions. Naturally, my last 100 bales were sold at the lowest price of the reaction.

A Second Attempt
A few days later the market appealed to me again. I could not dismiss it from my mind, nor could I revise my original belief that it was in for a big move. So I re-bought my 20,000 bales. The same thing happened. Up jumped the market on my buying order and, after that, right back down it came with a thud. Waiting irked me, so once more I sold my holdings, the last lot at the lowest price again.

If You Don’t Succeed at First, Try, Try Again - Except ….
This costly operation I repeated five times in six weeks, losing on each operation between $25,000 to $30,000. I became disgusted with myself. Here I had chipped away almost $200,000 with not even a semblance of satisfaction.

A Mood Not Conducive to Clear Thinking
So I gave my manager an order to have the cotton ticker removed before my arrival next morning. I did not want to be tempted to look at the cotton market any more. It was too depressing, a mood not conducive to clear thinking which is required at all times in the field of speculation.

One of the Most Attractive and Soundest Trades Lost
And what happened? Two days after I had the ticker removed and had lost all interest in Cotton, the market started up, and it never stopped until it had risen 500 points. I had thus lost one of the most attractive and soundest plays I had ever figured out.

Failure to wait for the Pivotal Point to be passed.
There were two basic reasons. First, I lacked the patience to wait until the psychological time had arrived, pricewise, to begin my operation. I had known that if cotton ever sold up to 12.5 cents a pound it would be on its way to much higher prices. But no, I did not have the will power to wait. I though I must make a few extra dollars quickly, before cotton reached the buying point, and I acted before the market was ripe. Not only did I lose around $200,000 in actual money, but a profit of $1,000,000. For my original plan, well fixed in mind, contemplated the accumulation of 100,000 bales after the Pivotal Point had been passed. I could not have missed making a profit of 200 points or more on that move.

Emotional Involvement - Unsound Trading Behavior
Secondly, to allow myself to become angry and disgusted with the cotton market just because I had used bad judgment was not consistent with good speculative procedure. My loss was due wholly to lack of patience in awaiting the proper time to back up a preconceived opinion and plan.

I have long since learned, as all should learn, not to make excuses when wrong. Just admit it and try to profit by it.

The Market Tells Traders When They Are Wrong
The market will tell the speculator when he is wrong, because he is losing money. When he first realized he is wrong is the time to clear out, take his losses, try to keep smiling, study the record to determine the cause of his error, and await the next big opportunity. It is the net result over a period of time in which he is interested.

John Wheeler is a theoretical physicist with a talent for memorable communication. In the nineteen-sixties he came up with the term “black hole” to describe the phenomenon we now know as…….. a black hole.

On scientific laws he offered: “There is no law except the law that there is no law.”

More generally, for anyone chasing knowledge, he said: “In any field, find the strangest thing and then explore it.”

So, in stock trading – or speculation - what is the strangest thing?

Surely it must be the large number of people willing to be losers so that others might gain.

Ours is a zero (or negative) sum game. On every stock index, one half of all shares traded must, on average, be traded for a loss, relative to the movement of the index itself. When trading fees and costs are taken into account, it’s plain to see that compared with buying the index there’s a net average loss associated with trading.

The winners must be a minority. So why on earth would anyone want to start trading?

Funnily enough, an answer comes from another theoretical physicist – the iconoclastic Richard Feynman.

In Surely You’re Joking Mr. Feynman, a collection of anecdotes about his life, he talks about his times in Las Vegas. Feynman, like Jesse Livermore, was a womanizer. He knew gambling was a sucker’s game but he liked visiting Vegas for the female company.

Here’s what he had to say about a visit to a casino:

….and she said “See that man over there, walking across the lawn? That’s Nick the Greek. He’s a professional gambler.”

Now I knew damn well what all the odds were in Las Vegas, so I said, “How can he be a professional gambler?”

“I’ll call him over.”

Nick came over and she introduced us. “Marilyn tells me that you’re a professional gambler.”

“That’s correct.”

“Well, I’d like to know how it’s possible to make your living gambling, because at the table, the odds are 0.493.”

“You’re right,” he said, “and I’ll explain it to you. I don’t bet on the table, or things like that. I only bet when the odds are in my favor.”

“Huh? When are the odds ever in your favor?” I asked incredulously.

“It’s really quite easy,” he said. “I’m standing around a table, when some guy says, ‘It’s comin’ out nine! It’s gotta be a nine!’

The guy’s excited; he thinks it’s going to be a nine, and he wants to bet. Now I know the odds for all the numbers inside out, so I say to him, ‘I’ll bet you four to three it’s not a nine,’ and I win in the long run. I don’t bet on the table; instead, I bet with people around the table who have prejudices - superstitious ideas about lucky numbers.”

Nick continued: “Now that I’ve got a reputation, it’s even easier, because people will bet with me even when they know the odds aren’t very good, just to have the chance of telling the story, if they win, of how they beat Nick the Greek. So I really do make a living gambling, and it’s wonderful!”

So Nick the Greek was really an educated character. He was a very nice and engaging man. I thanked him for the explanation; now I understood it. I have to understand the world, you see.

So, what’s the moral I take from this story?

Given the sheer number of suckers who make their way to Las Vegas hoping to win, but deep down knowing they’ll lose, and the numbers who lose money trading, it has to be that more people have an instinct for gambling than have an instinct for winning. They also like to experience the thrill of the game – whether it’s chasing the big win on the one armed bandits or on the trading screen. They like to talk about their experiences – “I beat Nick the Greek” or “I made 30% on the breakout”. Occasionally they’ll be lucky and have a big victory they can brag about. Losses are often kept quiet.

In addition to and tied in with the gambling behavior is the “I’m better than he is” attitude often seen in car drivers. Survey after survey shows the vast majority of drivers believe their driving is above average. Clearly it’s impossible for the majority to be above average at anything. People are systematically overestimating their own ability.

The trouble with trading is that a lot of books actually tell beginning suckers that, by following the advice of the book, they will become better than average traders. This reinforces their in-built car-driving/I’m better than he is attitude. Only bitter experiences and, sometimes, large losses change that.

For me, the willingness of traders to repeatedly lose money was the strangest thing in trading. What do you think?