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?

A couple of my recent articles have been about ‘gut feel‘.

I’m writing about gut feel for the last time today - about how our gut feel for numbers - probability/chance in particular - is inaccurate. This is important because trading is a game of chance. We should trade when we have the highest expectation of success.

Most of this post is taken up with the Monty Hall game. If you’re not already familiar with it, Monty Hall can be a surprising introduction to how we misjudge our chances of winning. I’ll begin, though, with a quick look at birthdays.

Gut Feel Misjudges Birthday Probabilities

How many people do you think would need to occupy a room for a 50/50 chance that two of them share the same birthday? The answer is 23.

For a 99%+ chance that two people share a birthday, only 57 people are needed.

These results are counterintuitive. Our gut feel is that more people should be needed.

Gut Feel Misjudges Chances of Winning a Game

Another well-known example of how our gut feel gets confused about probability is the Monty Hall Game - named after the host of the 1960s television quiz show Let’s Make a Deal.

Each week, Monty Hall would offer the contestant three doors. Behind one door was a big prize and behind the other two doors was nothing. Obviously, the contestant had a 1 in 3 chance of choosing the winning door.

Let’s imagine that you are a contestant.

You pick a door - the blue one - hoping to win the prize.

Then Monty has a bit of fun with you. Monty knows which door the prize lies behind. After you tell Monty your choice, he opens one of the doors to show you that the prize isn’t there.

Monty then asks you if you want to change your mind.

So what do you do? Stick with your first choice or change?

I’ll give you a moment to make your choice - try to choose without reading ahead.

Made your mind up? Good.

The correct answer is that you should accept Monty’s offer and change your selection to the yellow door. Doing so increases your chances of winning the prize.

Now, I must admit when I first heard this puzzle, my initial instinct was to stick with my original choice - I didn’t think it would make any difference switching doors. Surely, after Monty had shown me one empty door, I would have a 50/50 chance of winning the prize whether or not I switched my choice of doors. But, no, that’s not the case. In fact, after Monty has shown you one empty door, there’s a two-thirds likelihood that the prize lies behind the door you did not originally pick. Let’s see why.

First, you are presented with a choice.

You have a one in three chance of choosing the right door.

Second, you choose a door.

There is a one in three chance the prize is behind this door. There is a two in three chance that it lies behind another door.

Now Monty opens a door.

In doing so, he changes your chances, if only you realized it. There must still be a two in three chance that the prize lies behind one of the doors you haven’t chosen. You have now been shown which of these doors doesn’t have the prize behind it. This means that choosing the final door - the yellow door on the right - has a two-thirds chance of winning the prize.

Summing Up

If we rely on gut feel in activities involving probabilities we are likely to make big mistakes.

There’s a stock market saying that bulls can make money, bears can make money but the pigs get slaughtered. Make sure you leave gut feel to the pigs and write your trading plans using predefined, objective criteria.

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 want to talk a little more about how conditioned minds can prosper in trading. You’ll be relieved to know that I’m going to use a trader rather than a scientist as the example this time.

Jim Leitner runs Falcon Management in New Jersey. He has taken $2 billion profit out of the market in his career. Jim gave an interview to Steven Drobny for his book The House of Money. Jim’s mind has been conditioned by a huge amount of experience in trading, as follows:

• While studying international finance and Russian at graduate school, Jim worked half days as a “monkey” - a money broker trainee adding data from around the world to the big board for the brokers to see.
• While still working as a monkey, he started broking - calling small banks in the Midwest. He did this for two years.
• He then took a big salary cut to get more experience, working at J.P. Morgan, trading the Eurodollar market. Jim became an expert on euroswiss francs, eurodeutsche marks and europesetas.
• He then became an FX trainee with J.P. Morgan and then a currency forward trader.
• After a few years, Jim was hired by the Bank of America to run forwards, exotics and all currency trading outside the major currencies.
• He moved to Shearson Lehman as a proprietary trader.
• He moved to Banker’s Trust and spent five years trading currencies.

With all this experience behind him, Jim was asked whether he has an innate trading skill and can “just tell” when prices are out of line. He answered:

“I don’t have an innate skill. It comes from being extremely interested in markets and looking at everything all the time. After doing it for years I’ve developed a mental database of where things should be, such that when something makes an irregular move, it shows up on my radar screen. I used to have so much fun playing around in the market and knowing that I knew my markets better than other people.”

So here again, is an example of a conditioned mind prospering where others fail. Where others might claim an innate skill or a gut feel for trading, Jim Leitner attributes his success to conditioning of the mind - a mental database - built up from many years’ trading.

Jim Leitner’s hedge fund, Falcon Management, has a website. You can find out their address and their phone number but nothing else.

I’m off now to condition my own mind.