If you’ve never done much trading, the problem of how to deal with trades that move nicely in the right direction won’t seem like a problem – but it is. When a trade moves in the right direction you need to make as much money out of it as you can; remember that quote from George Soros I mentioned earlier this month, “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.”

Let’s say you’ve bought shares in Livermore Financial Services Inc. and the price has been rising in a satisfactory way – there’s a solid uptrend and it’s showing no signs of weakening. There are three ways of managing your trade:

Lock in Profits – sell some shares now so if the price falls suddenly, you’ll have locked in a good profit on the ones you’ve sold.

Pyramid – buy more shares hoping to further increase your profit.

Enjoy the Ride – neither increase nor decrease your position.

Which is best?

Academia Says:
I’ll begin by recalling the old joke that if you need three different opinions, put your question to two economists. Much the same can be said of theoreticians in finance. Joking aside, however, most finance theoreticians accept that price trends do develop and that stock prices are not always moving in a random walk.

If we assume that trending is real, (what success I’ve had in the markets is – at least in part – due to this assumption,) then it would be illogical to sell during an uptrend. You would be selling at a time when prices are likely to continue rising. The correct time to sell is after the uptrend has broken.

So, on this basis, I will rule out the “sell some shares to lock in profits” option. The best way of locking in profits is to move your stop-loss higher as your trade moves in the right direction.

Jesse Livermore Says:
If you were a gung-ho speculator like Jesse Livermore, you would pyramid. Strictly speaking - and as practiced by Livermore - pyramiding is a form of margin trading where you borrow against paper profits in a trade to increase your position in the same trade. (Later I’ll use the word pyramiding more loosely to include the practice of increasing your position in a trade using your own, unborrowed, money.)

Provided the trade continues to move in your desired direction, you will certainly increase your profits by pyramiding. In the unlikely event that, like Jesse Livermore, you were allowed to pyramid stocks using very high margin, and the trend suffered a sharp break, you would be in great danger of losing all of your profits, and more.

Managing Pyramiding Risk
Loss-minimization is crucial in trading. Your trading account can only survive long-term if, without fail, you get out of trades when their stop-loss is hit. Panic sell-offs are the trader’s nightmare because, under these conditions, you might not be able to sell your shares at your stop-loss price - you could get much less. Continually adding to a position in a single stock means that your losses during a panic sell-off could be catastrophic. For this reason I personally haven’t used pyramiding on a large scale and I’ve never attempted to do it on margin.

Instead of pyramiding in a single stock, I prefer to lower my risk by trading trending stocks in several different sectors. This way, if any one stock suffers a severe reversal and my stop-loss is missed, I don’t suffer a catastrophic loss.

There are more sophisticated ways of reducing trading risks and I’ll write about these another day – I don’t want to put too much into one post.

Conclusion
Pyramiding can be a useful way of increasing trading profits, but continually adding to your position in a single stock increases your risk of catastrophic loss.

By never increasing my position in any single stock beyond a reasonable level, I am more relaxed in a trade; it’s easier to enjoy the ride. If I’m enjoying myself and making good money from a trade, I can’t ask for any more.

At the peak of his career in 1929 Jesse Livermore was worth at least $100 million. When I talk to people about this, they sometimes ask me how much that’s worth in today’s money. As a rule of thumb, I tell them that a dollar in 1929 was worth about 10 times what it’s worth today – and Jesse’s fortune would have amounted to over a billion dollars in today’s money – a remarkable feat for a self-made stock trader.

To assess Jesse’s fortune more scientifically, the measuringworth calculator gave the following results for today’s value of $100 million in 1929:

$1.14 billion using the Consumer Price Index
$0.94 billion using the GDP deflator
$2.27 billion using the value of consumer bundle
$3.65 billion using the unskilled wage
$4.95 billion using the nominal GDP per capita
$12.0 billion using the relative share of GDP

In terms of the lifestyle Livermore’s wealth bought, Patricia Livermore, Jesse Livermore’s daughter-in-law gave a fascinating interview in 1990 for a documentary about the crash of 1929. Here’s part of what she said about the Livermore lifestyle:

“They had a beautiful place on 76th Street in Manhattan on the West Side, off Central Park. They had a floor at 813 Fifth Avenue because Dorothea did not like to go to the West Side to change her clothes. They had a house in Great Neck. They had a summer house in Lake Placid. They had a house in Palm Beach. They had a private railroad car, two yachts. The only yacht that was bigger was J. P. Morgan’s. And they used one of them, the big one, very frequently when they went to Europe. They lived very comfortably…

Jesse Livermore had a ticker tape in every home that he owned, on his railway cars, on his yachts… They had several Rolls Royces, lots of chauffeurs. They had a staff of about 20 or 25 and in each place, in each house, see, and with the exception of Dorothea’s personal maid, they did not take their staffs with them. They simply kept them year-round in all their establishments…

Oh, they lived. They really lived… Mrs. Livermore was a spender. And, of course, she loved to buy. She spent her days buying and buying and buying…”

I liked the quote from George Soros I used earlier this month, so I thought I’d dig out a few more words of wisdom.

In doing so, I’m well aware that this is precisely the kind of activity a sucker loves to engage in. Jesse Livermore said:

“The semi-sucker had read books about trading - usually written by yet higher grade suckers - but he did not realize that reading books was not the same as trading experience. This type of sucker could quote all sorts of wise sayings about the operations of the stock market. He did not lose money as quickly as the beginning sucker because he had learned some of the most rudimentary trading rules.”

Despite the fact that it might make me look like a sucker in Jesse Livermore’s eyes, here are a few quotes I’ve enjoyed – quotes I think even Jesse might have liked and approved of:

A banker: the person who lends you his umbrella when the sun is shining and wants it back the minute it rains.
Mark Twain

Remember your goal is to trade well, not to trade often.
Alexander Elder

The conduct of successful business merely consists in doing things in a very simple way, doing them regularly and never neglecting to do them.
William Hesketh Lever

There is a great difference between the best company and the best stock.
Ralph Wanger

Never risk more than 1% of your total equity in any one trade. By risking 1%, I am indifferent to any individual trade. Keeping your risk small and constant is absolutely critical.
Larry Hite

If you bet on a horse, that’s gambling. If you bet you can make three spades, that’s entertainment. If you bet cotton will go up three points, that’s business. See the difference?
Blackie Sherrod

I see the SEC is prosecuting a married couple for allegedly making $600,000 through insider trading. In Jesse Livermore’s day, ripping off the public through insider trading was legal but that, thankfully, changed a long time ago. The greed that attracts people to insider trading will never change though.

In an emergency civil action filed in the US District Court for the Southern District of New York, the Commission charged Ruben Chen and his wife Jennifer Xujia Wang with using online brokerage accounts in Wang’s mother’s name, Zhiling Feng, to purchase securities of three companies on the verge of announcing they would be acquired. Wang and Chen used non-public information from Wang’s employer, Morgan Stanley, which was providing services in connection with the acquisitions.

The Commission’s complaint alleges that Chen and Wang funded and exercised control over Feng’s online brokerage accounts. When Feng’s first brokerage account was opened, it was funded with money from a checking account in Wang and Chen’s name. In addition, Feng, who lives in Beijing, China, did not access the two online brokerage accounts that were opened in her name on the days of the relevant trading. Rather, most of the logins to the brokerage accounts were from Internet Protocol addresses at ING and from Chen and Wang’s home in New Jersey.

The Court has issued a temporary restraining order which, among other things, freezes the defendants’ assets and orders repatriation of funds taken out of the United States.

The Commission’s complaint alleges that Wang and Chen obtained illegal profits of more than $600,000 by trading on the basis of material non-public information before the public announcements of three acquisitions:

• Morgan Stanley Real Estate’s (MSRE) December 19, 2005 announcement of its acquisition of Town & Country Trust;
• MSRE’s August 21, 2006 announcement of its acquisition of Glenborough Realty Trust; and
• Formation Capital, LLC and JER Partners’ January 16, 2007 announcement of its agreement to acquire Genesis HealthCare Corporation.

Since August 29, 2005, Wang has been employed as a Vice President of Morgan Stanley in a group that supported the Principal Transaction Group, which provides financing for MSRE potential acquisitions. Wang received documents via e-mail and had access to documents on a shared network drive, which demonstrated that the firm was providing financing on certain acquisitions before they were publicly announced.

It’s important that stock traders should understand a trading strategy’s expected profit pattern. So I thought I’d mention the Pareto Principle and its relevance to stock trading.

Vilfredo Pareto was an Italian economist who observed that 80 percent of Italy’s income ended up in the hands of just 20 percent of the population. Anyone who has spent more than a couple of weeks in business school will have heard of the Pareto Principle, which says that - in many fields of endeavor - 80 percent of the consequences arise from 20 percent of causes.

The split need not be precisely 80-20.

80-10, 80-25, 90-5, 90-10, 90-20, etc splits would still conform to the Pareto Principle.

Examples of the Pareto Principle might be:

• 80 percent of laughs come from 15 percent of jokes.
• 80 percent of excellent movies are made by 20 percent of movie directors.
• 90 percent of crime is caused by 20 percent of the criminal population.
• 85 percent of useful quotes about the stock market come from just 10 percent of financial writers.

Richard Dennis once said, “Ninety-five percent of my profits have come from five percent of my trades.”

Although the Pareto Principle is too recent for Jesse Livermore to have been familiar with it, his own trading experiences led him to formulate a trading strategy that should have produced a Pareto type profit distribution. My own experience of trading in accordance with Livermore’s principles is that it does just that. Around 75 percent of my profits come from just 25 percent of my trades. This is a natural consequence of sticking with a small number of trades for many months, but cutting short lots of trades that perform less well.

In Reminiscences of a Stock Operator, Edwin Lefèvre relates something of how James R. Keene, who made his fortune trading U.S. stocks in the 19th century, operated:

“What happens is plungers like him make so much [money] when they are right that it takes quite a few mistakes to make a dent in their pile.”

George Soros encapsulated successful trading perfectly when he said:

“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.”