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.”

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.

Last week, I wrote about one of Jesse Livermore’s triumphs. This week, however, it’s a tragedy I’m writing about.

Seventy-three years ago, on March 19 1934, Time Magazine reported Jesse Livermore’s final bankruptcy.

From the 1929 pinnacle of his career, when he shorted the market for a profit of $100 million, less than five years had passed.

A few months earlier, Jesse Livermore had gone missing and his wife had called in the police. A day after disappearing he had returned home, walking unsteadily. He had spent the night in a hotel and had awoken with a blank mind. Reading newspaper headlines about his disappearance brought him to his senses. His doctor’s verdict: “Amnesia nervous breakdown.”

It’s likely that during this period of his life, Livermore was suffering badly from the clinical depression he suffered from at various times.

He listed liabilities of $2,259,212.48, and assets of $184,900, mostly life insurance. (He also had large annuities bought to protect his family in the event of bankruptcy.)

Livermore’s financial plight also produced further evidence, adding to his reputation as a womanizer:

To Lucille Ballantine - a dancer - he had promised to pay $150 per month for five years for keeping him “cheered and amused” while he was getting his second divorce.

A former employee - Naida L. Krasnova - was suing him for breach of promise. (Claiming he had promised to marry her.)

Time commented: “Perhaps Jesse L. Livermore will come back as he has done three times before. That was what his lawyers had in mind last week when they declared: ‘Mr. Livermore has made three very large fortunes. … He has failed three times, on each occasion [he] has paid 100 cents on the dollar with interest, and hopes to do so again.’ ”

Sadly, on this occasion, the lawyers’ optimism was misplaced.

Jesse Livermore learned the art of stock market stings, manipulating the price of thinly traded stocks, in bucket shops.

83 years ago today, March 13, 1925, Arthur Cutten - one of his biggest rivals - accused Livermore of continuing his shady dealings - not in bucket shops - but, very seriously, on the Chicago Futures Exchange.

At the beginning of his career, Jesse Livermore had traded exclusively in bucket shops. He had prospered and built up his funds. Bucket shops weren’t set up to lose money, however, and soon the bucket shops were refusing to deal with Livermore or, worse, were cheating him.

Livermore’s response was to select crooked bucket shops to trade with. He would then build their confidence by losing in several smaller trades. Then came a big trade - and the sting. At the bucket shop, Livermore would place a trade on a stock that was only thinly traded on the NYSE. He would then trade the shares on the NYSE to move the actual stock price substantially in the required direction. The new price would come through to the bucket shop and Livermore would win big.

Although Livermore stopped trading in bucket shops, Arthur Cutten suspected Livermore continued to operate sting operations.

Time Magazine (May 25, 1925) carried the story of the events of March 13, when “Jesse L. Livermore (Manhattan) and Thomas Howell (Chicago) loosed an avalanche of wheat and rye that proceeded right through the bottom of the grain market.”

This was one of Livermore’s legendary “bear raids” when he would unleash wave after wave of short selling on a carefully selected stock or commodity.

Time Magazine continues, “Mr. Arthur Cutten (Chicago) was notably annoyed… because he, the big holder of wheat and rye, was feeling bullish, and his enormous paper profits were being swept rudely into oblivion.”

“Mr. Cutten felt that the catastrophe had been timed purposely to do him injury, since it happened while he was on an automobile excursion, out of touch with his agents.”

According to rumor at the time, Cutten’s huge “bull account” provided a tempting target for the bears, whose assault was made so powerfully that Cutten was forced to sell some 8,000,000 bushels of wheat in Winnipeg, helping the decline and enabling the bear raiders to cover easily. The bear raids would certainly have demolished much of Arthur Cutten’s large paper profits resulting from the rise of grain prices during 1924.

Cutten blamed the fall in wheat to the manipulative tactics of a “master speculator” in Florida, supported by a powerful group of interests.

“U. S. Secretary Jardine was alarmed because the simultaneous action of the Messrs. Livermore and Howell suggested possible collusion to manipulate grain prices - a practice painstakingly prohibited by the Capper-Tincher Grain Futures Act.

“Mr. Cutten could do nothing about it save abuse the Messrs. Howell and Livermore beneath his breath and hope with a great hope that Secretary Jardine would order an investigation, discover collusion, punish his oppressors.

“Investigate, Secretary Jardine did… but not one of the investigators had yet run upon any proof of correspondence between the Messrs. Livermore and Howell nor any records of sales in those gentlemen’s names executed in other than legitimate ‘contract’ markets.

“As far as the evidence went, it was mere business acumen that had moved them separately to sell their grain at the same time and keep on selling until it was time to buy again and start the price-swing going upwards.

“Messrs. Livermore and Howell are alleged to have made between them some 22 millions on the operations. Some Europeans lost much money; others saved much by buying necessary wheat shipments when the price was down.

“From the U.S. standpoint, this latter feature was not creditable to the Messrs. Livermore and Howell as an ‘economic service,’ for the U.S. farmer lost a fat slice from prices he had hoped to command this month and next.

“Last week, it seemed that the most important result of last Black Friday would be recommendations from Secretary Jardine that the Boards of Trade institute rules limiting the fluctuation of grain futures prices in a single day - rules similar to those found beneficial on the Cotton Exchange.”

I recall a discussion I had around 5 years ago with a semi-sucker.

This particular semi-sucker had misunderstood a trading book. He believed it should be possible using money management techniques to beat the casino at roulette. Provided he could cut his losses (by leaving the casino when he was losing) and let his profits run (by continuing to play when he was winning) he was “bound to make money”.

Now, I know this gambling strategy sounds superficially similar to Livermore’s strategy of quickly closing losing trades and allowing winning trades to run: but there’s one crucial difference. Livermore’s strategy – through his tape reading and trend following – had positive mathematical expectation. ^*

The suckers who play roulette in casinos do so under the handicap of negative expectation. It’s the casino owners who enjoy positive expectation – why else would they be in the business? The direction of money flow is from a casino’s customers to its owners.

Money management can’t turn a game with negative expectation into one you can win – it can only keep you playing longer. All that our semi-sucker friend could hope to achieve was more nights at the casino. Eventually, the casino would take all of his money.

The same outcome awaits the sucker who begins trading when his mathematical expectation is negative. Unless he is lucky, money will flow from him to people who have better trading strategies than he does. If he wins through good luck, the more often he plays, the likelier it is that his luck will run out.

The good news is that some markets are more forgiving than others. Given the long-term uptrend of the major stock indices, it’s often possible to turn a profit on long stock trades, even if you have poorer than average trading skills. Your profit will, of course, be lower than if you had simply put your money into an index-fund. And, with below average skills/knowledge/strategy, you’re more likely to end up with a big loss than a small profit – especially if you trade frequently.

^* Mathematical Expectation: Your chances are 50/50 when you bet on the toss of a fair coin. If the coin is loaded, however, and it landed heads more often than tails, then betting on heads has positive expectation and betting on tails has negative expectation.