In his 1987 letter to shareholders, the masterfully quotable Warren Buffett said, “If you’ve been in the [poker] game 30 minutes and you don’t know who the patsy is, you’re the patsy.”

In the same letter, he said, “If you aren’t certain that you understand and can value your business far better than Mr. Market, you don’t belong in the game.”

Four Grades of Sucker

The equally masterful quote-smith, Jesse Livermore, categorized four grades of sucker:

The Beginning Sucker: has read little and knows little.

The Semi-Sucker: has read books about trading - usually written by higher-grade suckers. He can recite wise stock market sayings. He does not realize that reading books is not the same as trading experience. He loses money more slowly than the beginning sucker because he has learned some basic trading rules.

The Wall Street Fool: knows enough to make a profit if he sticks faithfully to his trading rules. The excitement of the market overpowers the fool; he trades more often than he should and loses his advantage over the market.

The Higher Grade Sucker: makes his money from selling trading books because he can’t make money in the markets.

Although Buffett and Livermore are at opposite ends of the financial spectrum in terms of buy and sell criteria, they wholeheartedly agree that if you don’t have some advantage over average market participants, you’ll lose money.

There are a lot of intelligent players in the markets and plenty of fools too. Unfortunately, too many stock market books try to persuade their readers that fools predominate, lulling the semi-sucker into a false sense of security. If only you will do what it says in the book (often with too little detail to put together a truly effective trading strategy) you’ll be successful.

Before you trade, you should have some idea of where your advantage is coming from. You should paper trade to verify your advantage.

Then you need to trade for real – this is hardest of all because once you have your own money in the markets, your emotional involvement increases. The emotions – greed and fear start kicking in - cause difficulties for many traders. Some find the advantage they thought they had evaporates.

So, do you call yourself a beginning sucker, a semi-sucker, a Wall Street fool, a higher-grade sucker or a successful trader? The best test is the direction of your trading account balance over several years. As an alternative, though, you could try passing the Stock Market Sucker Test.

In How to Trade in Stocks, Jesse Livermore discussed “the folly of trying to find out a good reason why you should buy or sell a given stock.”

He wrote in the context of the behavior of U.S. stocks, whose four major sectors - including steel makers - had risen after World War 2 began. While other sectors continued to advance, U.S. steel stocks stopped rising.

Livermore wrote that there must have been a good reason why the steel stocks had stopped rising but he didn’t know what it was.

It was not until four months later that the public was given the facts and the action of the steel stocks - which had by now fallen 26 to 29 points - was finally explained. The British and Canadian governments had been selling large volumes of shares in U.S. steel makers. (Presumably to fund their war efforts.)

“If you wait until you have the reason given, you will have missed the opportunity of acting at the proper time!

“The only reason an investor or speculator should ever want to have pointed out to him is the action of the market itself.

“Whenever the market does not act right or in the way it should - that is reason enough for you to change your opinion and change it immediately.

“Remember: there is always a reason for a stock acting the way it does.

“But also remember: the chances are that you will not become acquainted with that reason until some time in the future, when it is too late to act on it profitably.”

As you can see, I’ve spent some time upgrading the site in the last couple of days. I hope you’ll find the new Most Popular Posts and Tagging features helpful.

Since we’ve reached the end of the year (I’ll add a belated Happy Christmas to everyone) I’ve looked over this year’s posts and picked out the five I liked best. These range from the comic (well, I tried my best…!) to trading methods to biographical. In no particular order, I’ve picked:

You know you’re under Jesse Livermore’s spell when…
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 start talking about the size of the line you’re swinging. You often begin sentences with the words “There I was…” […]

Investing Books - A Lesson from History
In 1998 the investor announces that, having read Mr. Fisher’s book, he has decided to invest all of his money!!! in Coca-Cola. Here’s Coca-Cola’s stock price chart since 1997 (with all of the reviewer’s money invested in it!).

Accurate Stock Picks vs Precise Stock Picks
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. […]

Pyramiding, Locking in Profits, or enjoying the Ride
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.”[…]

Jesse Livermore in 1907
February 1907 - exactly one century ago - was an exciting year for Jesse Livermore. In 1906, he had hit the big time - profiting by over a quarter million dollars - by shorting the market just before the San Francisco earthquake. It was at about this time that Livermore consciously began changing his trading style. He decided that the key to success lay in […]

I also loved the two guest posts in November from

Chuck Gray - Pretty Girls - You are Bad Trades

and David Wallace - Mathematicians and Physicists Emerge From Geekiness To Dominate Hedge Fund Trading

By the way, high quality guest posts that would be of interest to Jesse Livermore readers are still very welcome - you’ll get full credit for the post – attribution to your name (or pen name) and, if you have your own stock related blog or site, you can add a link to it.

Click on Contact near the bottom of the navigation links on the left-hand side if you want to send in a post.

And that’s it for 2007.

All I have to do now is to wish each and every one of you a stimulating, successful and – above all – a HAPPY 2008!

On October 24 1907, Jesse Livermore made his first $1,000,000.

Summer 1907, Jesse had sailed to France. His account balance stood at three-quarters of a million dollars, made shorting the markets. Here’s how, in Reminiscences of a Stock Operator, Jesse Livermore describes how he made his first million dollars

Vacation Time
“I was in Aix-les-Bains enjoying myself. I had earned my vacation. It was good to be in a place like that with plenty of money and friends and acquaintances and everybody intent upon having a good time… Wall Street was so far away that I never thought about it… I didn’t have to listen to talk about the stock market. I didn’t need to trade. I had enough to last me quite a long time, and besides, when I got back I knew what to do to make much more than I could spend in Europe that summer.”

Jesse Livermore Smells Market Manipulation
“One day I saw in the Paris Herald a dispatch from New York that Smelters had declared an extra dividend. They had run up the price of the stock and the entire market had come back quite strong. Of course that changed everything for me in Aix. The news simply meant that the bull cliques were still fighting desperately against conditions - against common sense and against common honesty, for they knew what was coming and were resorting to such schemes to put up the market in order to unload stocks before the storm struck them.”

Insiders Begging To Be Shorted
“At all events, I knew that all bull manipulation was foredoomed to failure in that bear market. The instant I read the dispatch I knew there was only one thing to do to be comfortable, and that was to sell Smelters short. Why, the insiders as much as begged me on their knees to do it, when they increased the dividend rate on the verge of a money panic. It was as infuriating as the old “dares” of your boyhood. They dared me to sell that particular stock short.”

Livermore Starts Selling Smelters Short
“I cabled some selling orders in Smelters and advised my friends in New York to go short of it. When I got my report from the brokers I saw the price they got was six points below the quotations I had seen in the Paris Herald. It shows you what the situation was. My plans had been to return to Paris at the end of the month and about three weeks later sail for New York, but as soon as I received the cabled reports from my brokers I went back to Paris. The same day I arrived I called at the steamship offices and found there was a fast boat leaving for New York the next day. I took it. There I was, back in New York, almost a month ahead of my original plans, because it was the most comfortable place to be short of the market in. I had well over half a million in cash available for margins.”

Livermore’s Shorting Gains Momentum
“From the latter part of September on, the money market was megaphoning warnings to the entire world. But a belief in miracles kept people from selling what remained of their speculative holdings… Things got worse and worse. Finally there came the awful day of reckoning for the bulls and the optimists and the wishful thinkers and those vast hordes that, dreading the pain of a small loss at the beginning, were now about to suffer total amputation—without anaesthetics. A day I shall never forget, October 24, 1907.”

Livermore’s Conscience Kicks In - And An Instinct For Profit
“I had enormous paper profits and the certainty that all that I had to do to smash prices still more was to send in orders to sell ten thousand shares each of Union Pacific and of a half dozen other good dividend-paying stocks and what would follow would be simply hell. It seemed to me that the panic that would be precipitated would be of such an intensity and character that the board of governors would deem it advisable to close the Exchange.

“It would mean greatly increased profits on paper. It might also mean an inability to convert those profits into actual cash. But there were other things to consider, and one was that a further break would retard the recovery that I was beginning to figure on, the compensating improvement after all that bloodletting. Such a panic would do much harm to the country generally. I made up my mind that since it was unwise and unpleasant to continue actively bearish it was illogical for me to stay short. So I turned and began to buy. It wasn’t long after my brokers began to buy in for me— and, by the way, I got bottom prices—that the banker sent for my friend.

No Longer a Gambler, but an Intelligent Trader
“I came out of it in fine shape. The newspapers said that Larry Livingston, the Boy Plunger, had made several millions. Well, I was worth over one million after the close of business that day. But my biggest winnings were not in dollars but in the intangibles: I had been right, I had looked ahead and followed a clear-cut plan. I had learned what a man must do in order to make big money; I was permanently out of the gambler class; I had at last learned to trade intelligently in a big way. It was a day of days for me.”

I don’t write too often about recent market action. Jesse Livermore liked to say that speculation was as old as the hills and I’ve tried to make most of my writing here “timeless” rather than “market commentary”.

I thought though, given the scale of the sub-prime problems, I would look at two of the best known stocks that have suffered in the crisis and how Jesse Livermore’s trading rules would have kept anyone who uses them out of trouble.

I’ll mention in passing that a senior contact I have at a well-known investment bank has tipped me that his own company has suffered enormous losses in debt instruments this year.

Like all the tips I get, I’ll not make much use of it – other than to pass it on here. After being stung once too often, Jesse Livermore learned not to act on inside tips – he found that acting on price and volume data was more profitable than acting on tips. Furthermore, although my contact’s bank hasn’t yet announced its losses, several others – such as UBS and Citigroup have.

So how would Jesse Livermore’s rules have kept us out of trouble?

Livermore’s number one trading rule was:

Buy rising stocks and sell falling stocks.

So let’s have a look at two of the highest profile stocks to have suffered in the US and UK stock markets recently.

Firstly, there’s the Northern Rock Bank in the UK – the only UK bank in living memory to have suffered a run, as customers queued for hours to get their money back. Here’s Northern Rock’s price chart from Yahoo Finance. There has been a clear downward trend for a considerable time and so – according to Livermore - the stock has been a clear SELL for some time. Selling sooner rather than later would have protected investors from the recent price collapse.

Northern Rock Chart 2007

Secondly there’s Countrywide Financial Corporation in the US. Again there has been a clear downward trend for a considerable time and so the stock has been a clear SELL for some time.

Countrywide Chart 2007

What’s interesting is that credit ratings agencies continued to give healthy credit ratings to companies which have run up against severe liquidity problems. The agencies’ analytical skills were unequal to the task of measuring the risks in the sector. In other words, while fundamental analysis continued to point to the financial health of many finance companies, the market itself was taking a less rosy view and stock prices had been trending downwards.

Jesse Livermore’s trading rule is as valid today as it was one hundred years ago:

Buy rising stocks and sell falling stocks.

(1) Jesse Livermore was born July 26, 1877. Some other events that took place in this year were: Queen Victoria became Empress of India, Crazy Horse fought his last battle with the US Cavalry, Mars’ outer moon Phobos was discovered and Thomas Edison invented the phonograph.

(2) From his earliest days, Livermore spent the money he took from the markets freely - enjoying the sort of lifestyle more usually associated with Hollywood’s biggest stars.

(3) He was a cigar smoker.

(4) His favorite hobby was fishing and he also enjoyed hunting and playing golf.

(5) He took long vacations – often in Florida for a month or more in winter - or sailing to European resorts in his ocean-going yacht.

(6) He believed his breaks from routine - when sailing or fishing - allowed him to have some of his best ideas.

(7) He was a three-times married womanizer.

(8) Throughout his life, he suffered from clinical depression.

(9) Jesse Livermore died, aged 63, on November 28, 1940. Some other events that took place in this year were: Germany invaded France, Winston Churchill become Prime Minister of the UK and Franklin D. Roosevelt was re-elected US president.