I thought I’d make a quick post to commemorate the fact that it’s 130 years since Jesse Livermore was born.

Although his family might have given him birthday presents, Jesse Livermore never expected the stock market to be so generous. He said:

“I could build a huge hospital with the birthday presents that the tight-fisted stock market has refused to pay for.”

He wasn’t speaking only of himself. He was expressing his concern for people who trade with a view to buying something nice with trading profits.

“In fact, of all hoodoos in Wall Street I think the resolve to induce the stock market to act as a fairy godmother is the busiest and most persistent.

“There isn’t a man in Wall Street who has not lost money trying to make the market pay for an automobile or a bracelet or a motor boat or a painting.

“Like all well-authenticated hoodoos this has its reason for being. What does a man do when he sets out to make the stock market pay for a sudden need? Why, he merely hopes. He gambles. He therefore runs much greater risks than he would if he were speculating intelligently, in accordance with opinions or beliefs logically arrived at after a dispassionate study of underlying conditions.

“To begin with, he is after an immediate profit. He cannot afford to wait. The market must be nice to him at once if at all. He flatters himself that he is not asking more than to place an even-money bet. Because he is prepared to run quick—say, stop his loss at two points when all he hopes to make is two points—he hugs the fallacy that he is merely taking a fifty-fifty chance. Why, I’ve known men to lose thousands of dollars on such trades, particularly on purchases made at the height of a bull market just before a moderate reaction. It certainly is no way to trade.”

Happy Birthday Jesse

When I wrote last month about trades that are worth taking, I was careful to say we should be looking for trades that engage the interest of other investors or traders.

I wasn’t, of course, saying anything original. We face the same situation as generations of traders before us.

A couple of days ago, I was fighting my way through a couple of chapters of Maynard Keynes’s General Theory of Employment, Interest and Money. I found Keynes had written entertainingly about the subtle art of picking winning trades. In 1936 he wrote (and I paraphrase):

You Think She’s Pretty - But Will Other People Agree?

Professional investment may be likened to those newspaper competitions in which you have to pick out the six prettiest faces from a hundred photographs. The prize will be awarded to the reader whose choice most closely matches the average preferences of all the other readers.

This means you have to pick, not those faces you find prettiest, but those you think other readers will pick as the prettiest. Of course, all of the other readers are also going to look at the problem from the same point of view. So, to win the prize:

1. You shouldn’t pick the faces you think are really the prettiest.
2. You shouldn’t even try picking the faces you think average opinion will find the prettiest.
3. You have reached the third stage where you try to figure out what average opinion expects the average opinion to be.

And there are some who practice the fourth, fifth and higher degrees.

Jesse Livermore concluded, through trial and error, that the biggest profits are made through being fully invested while markets are trending strongly.

Others have learned to profit from trendless markets - trading ripples in the market.

In Staying Ahead of the Curve, George Soros describes how Victor Niederhoffer had a system for trading these ripples and how, eventually, it failed.

“He was well grounded in random walk theory. He looked at markets as a casino where people act as gamblers and where their behavior can be understood by studying gamblers. For instance, gamblers behave differently on Mondays than on Fridays, differently in the morning than in the afternoon, and so on. He regularly made small amounts of money trading on that theory. I gave him money to manage and he made a good return on it.

“There was a flaw in his theory however. It is valid only in a trendless market. If there is a historical trend, a tide, it can overwhelm these little waves that are caused by gambling behavior and he can be very seriously hurt because he doesn’t have a proper fail-safe mechanism.

“He made very good money while the markets were sloshing around aimlessly. Then he started losing money, and he had the integrity to close out the account. We came out ahead. Very few commodity traders would have done that.”

Get Your Trading Strategy Right

• Some traders trade a single market (or just two or three) - changing their tactics depending on whether the market is trending, trendless, or showing a reliable chart pattern.
• Others trade a single tactic - such as only trading head and shoulders chart patterns - and scan the markets for indices, stocks and commodities, in search of these opportunites.
• Still others take a more à la carte approach, mixing and matching tactics and markets wherever they think they can make a profit.

In his earliest years, Jesse Livermore day traded successfully using price/volume correlations.

Later he acted on - and then ruled out - using tips and inside information.

Finally, he used macroeconomic data as a guide where the market ought to be moving and then looked for pivotal-point trades in stocks and markets which had begun to trend.

Jesse Livermore was one of the world’s most famous (or infamous) stock traders.

Now, almost 80 years after his fame peaked, many people still regard him as one of the greatest stock traders ever. With this in mind, here are some ways of assessing how deeply you’ve come under the influence of Jesse Livermore.

You know you’re under Jesse Livermore’s spell when:

• You tell anyone who’ll listen that “there is nothing new in Wall Street”.
• You forget everything you’ve ever learned about position sizing and put all of your own money (and ten times more from your broker) into a single trade.
• You tell people, “never argue with the tape”.
• You tell your (male) children to keep their cash close to their balls and never let anyone near it.
• You start talking about the size of the line you’re swinging.
• You have your best ideas while big-game fishing off the coast of Florida.
• You often begin sentences with the words “There I was…”
  • “There I was, once more broke, which was bad, and dead wrong in my trading, which was a sight worse.”
  • “There I was, short five thousand shares of Union Pacific on a hunch.”
  • “There I was on the morning of May ninth with nearly fifty thousand dollars in cash and no stocks.”

You know your wife’s under Livermore’s spell when:

• She starts paraphrasing his famous dictum “A stock can never be priced too high to buy” – but replaces “stock” with “necklace”, “shoes”, “dress”, “designer kitchen”, “bathroom suite”, or “vacation”.
• She repeatedly tells you, “there is nothing new in Wall Street my wardrobe”.
• She forgets everything you’ve ever told her about position sizing and puts all of your money (and ten times more from your bank) into her dream house.
• She tells you, “never argue with the tape me”.
• She often begins sentences with the words “There I was…”
  • “There I was, embarrassed because everyone else was better dressed than I was.”
  • “There I was, the only one not having an overseas vacation this year.”
  • “There I was, the only one whose husband hadn’t come too.”

A Quick, Easy Physics Lesson

Once upon a time, I taught physics. Among hundreds of other topics I covered, I taught students the difference between accuracy and precision. Although a lot of people use the words interchangeably, accuracy and precision are actually different things.

If you aim bullets at a target they might hit it with high precision – a tightly grouped bunch of hits – but low accuracy – your hits are far from the bulls-eye.

Precision AND accuracy are achieved when you get a tight grouping of hits on the bulls-eye.

Working Hard NOT to make Money

When you’re trading, or investing, it’s more important to be accurate than precise. If you have a big idea that’s wrong, you can analyze it to the nth degree, but it’s still not going to make money. Since the first rule of trading and investing is to avoid losing money, you’ve got to be accurate with your big ideas. If your big idea is right, you’ll have to work hard at it not to make money.

Accurate Investing - the Big Idea

A big idea that I caught onto a few years ago was the idea of peak oil. I could write pages and pages about this, but I won’t. Suffice to say that oil is a finite resource. The US has already passed its peak of production, as has the UK. Oil is being consumed faster than it’s being discovered. There are huge reserves of “alternative oil” around the world but the large-scale viability of these resources – such as Alberta’s oil sands – demanded much higher oil prices than the $20 - $30 per barrel that crude oil was trading at five years ago.

So a good “big idea” was to invest in oil stocks.

Some stocks have done better than others, but provided you caught the big idea, you were almost bound to avoid loss and make a decent return. If you did something obvious, like buying Exxon (XOM) you’d have made 100% in the last five years, or Royal Dutch Shell (RDS-B) 60%. If you did the opposite and invested in GM or Ford, who were busily building a new generation of gas-guzzlers, you’d be down 29% and 41% respectively. You see the value of getting your big ideas – your accuracy – right?

Precision Investing - making the most of a Big Idea

If you’d thought a bit deeper, you might have been able to make more money from your oil trade – this time by improving your precision and identifying a nice tight grouping of the highest profitability trades to express your big idea. You don’t need to put money into all of these - but at least you’ve identified a tight group of stocks that should deliver you the highest rewards.

For example, the oil sands that I mentioned in Alberta were marginal or unprofitable at $20 - $30 oil. A big increase in oil prices would almost certainly give a bigger boost to oil-sand company’s profits than to Exxon’s. In fact, the Canadian Oil Sands Trust (COS-UN.TO) has quadrupled in price over the last five years while Suncor (SU) has quintupled and UTS Energy (UTS.TO) has sextupled.