catalogue v 40

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Stocks & Commodities V. 1:4 (82-85): The Livermore System by JESSE H. THOMPSON/Technical Analysis staff writer

The Livermore System

by JESSE H. THOMPSON/Technical Analysis staff writer

Livermore is one of those names you might hear floating around among the chatter and ticks inside the

local brokerage office. Or maybe you will catch a reference to him in some obscure article or book. Just

as the markets of the various exchanges are often mystifying, so too are many of the historical characterssurrounding the markets.

Jesse L. Livermore was one of those characters, passing in and out around the Wall Street of thel890-1940 period. The classic "rags to riches" stereotype of this period. Humble beginnings as a NewEngland "dirt farmer", impoverished, uneducated, but gifted with a natural ability for numbers and

mathematics and possessing an acute memory of figures. He died in 1940, impoverished, depressed, buthopefully greatly humbled and a lot wiser. In between were 30-40 years of spectacular trading in thestock, cotton and grain markets pulsating out of Wall Street. He amassed millions and lost millions

several times. His name appeared often in the pages of the major newspapers and magazines of the time.Idolized and despised. "Livermore Heads Bear Raid!" shouts one article and among the folks back homesitting around the standup radio conversing it wasn't uncommon to overhear someone swoon: "If I only

had Livemmore's money!"

His story is an educational one, for his ability to amass great fortunes in the market place was testimonyto his understanding of the markets, while his ability to lose the same also testifies to the susceptibility of

the trader to the human element.

Being unfamiliar with the particular circumstances under which he lost the greater parts of his fortunes,

one can only speculate as to the causes. I surmise that after a series of successful campaigns in themarketplace, he became lost in the grand illusion created by the roar of publicity and adulation. Thisprobably sprouted the seeds of his next disaster, for brimming with confidence (from recent successes)

backed by a deep pocket of millions, he probably began to believe he could control the market. Boldnessled to anticipation and over committment. Bad decisions yielded to stubborness and disbelief. By the timereality had set in, he had given back millions. Humbler and wiser, he was forced to return to the strict

trading principles underlying his past successes. He then entered the market, again to realize anotherfortune but again falling prey to the human element. The character of markets combined with stubbornessor the inability to detect major changes can be merciless. This is the value of a stop loss order.

The methods that he employed that are the prime interest of this article are the technical methods and thedevelopment of those methods. His early beginnings in Wall Street fit into the historical framework ofthe early development and use of technical analysis of stock and futures markets. An understanding of the

development and application of those methods can be helpful in the understanding of today's markets.

First, we will touch on the early development of his methods. Next, outline the basic concept, itself as

interpreted by this writer. And lastly, we will trade one of today's popular stocks using his basic methodsand illustrating the various principles therein.

The development of Livermore as a trader and of his methods in particular, begins at the age of fourteen

as a quotation "board boy'' in the Wall Street of the 1890's. Usually, in that era one of the customer's

Article Text 1Copyright (c) Technical Analysis Inc.




would stand around the ticker tape and call out the prices of various stocks as they came across the tape."Board boys" would stand by with chalk in hand marking the prices of the stocks they were in charge ofon a tall slate board. After marking and watching prices day after day, he discovered that stocks exhibited

what he called certain "habits" prior to an advance or decline of significance. These "habits" are in today'slingo coined "chart patterns," "chart formations," or "pattern recognition."

Since he was quick with figures and had a good memory, he began to recognize these "habits" that he hadidentified and to use his interpretation of their meanings to anticipate impending price movements.Livermore started to get pretty good at his guesses based on his observation of "habits", so naturally whenspare time would allow, he and the other "board boys" would rush off to wager in the "bucket shops."

During the 1890's, "bucket shops" had mushroomed all over New England. These were usually small,privately owned parlors that employed a very similar concept to today's option markets. People could go

into these parlors and make wagers on future price activity of the stocks trading on the stock exchanges.The margin was usually two points, so that if you "purchased" a stock at 90 and it soon declined to 88you were wiped out and your "position" (which was imaginary) was liquidated. If you "purchased" a

stock at 90 and it did not decline to 88 but rose to 94, you could "sell" out your position for a four dollar

profit.

Since the margin was so small, the clientele of these parlors were usually those that were not capitalized

enough to trade the actual shares. For Jesse Livermore, the poor board boy, this offered the perfectvehicle for him to apply and develop his methods of trading. Becoming more skilled, he began to makemore money speculating than he drew down in his job as a board boy. From that point on he traded

primarily for his own account.

Accumulating enough capital in the "bucket shops", he reached the stage where he was capitalized

enough to trade the actual shares on the exchanges. Thus began his career as a professional trader. Duringhis days of fame and fortune, he was provided with a special suite at the brokerage house of Harrimanand Company on Wall Street. He had a fully equipped private boardroom for his own use. In it were

several tickers from the major stock, cotton and grain exchanges, an office with several phones and mostespecially a tall slate board with about 30 active stocks, cotton and grain options listed across the top.

Daily quotes were listed in long columns, one below the other. The arrangement of prices in this fashion

probably originated from his experiences as a "board boy". They were also probably a tool, inimplementing and fine tuning his exit and entry from the markets. Price moves in a vertical fashion, upand down along a horizontal time axis, so it seems rational to structure his recording method along the

same lines. A similar method familiar to some technicians of today is the use of a swing chart.

He also had special paper printed to record daily activity. This paper consisted of lined paper with long

columns running the length with headings across the top reading: "Secondary Rally, Natural Rally, UpTrend, Down Trend, Natural Reaction, and Secondary Reaction." Price was recorded vertically and time(the dates prices occured) were also recorded vertically along the far left side of the paper, across from

the corresponding prices. He categorized the type of activity horizontally, in one of the six categorieslisted above.

He defined a swing of $6, for active stocks around $30 or higher, as being significant enough to fall into

one of the six categories. His intent was to filter out the minor moves so he could have a clear picture ofthe major trends in force. Changes in character of price activity were also further defined by $3penetrations or more of significant price levels he called "pivot points."





It is sometimes easier to observe and understand this method applied in actual practice, so using a 6 point

swing chart, we will apply this method to the trading of Homestake Mining stock. We will capitalize anaccount with an amount Livermore might have used and by applying the basic principles of this system,trade Homestake Mining.

Two things to keep in mind, while going through this exercise. First, that he probably applied finer tuningtools in conjunction with this method to improve his net returns. Second, the purpose of this exercise is

not to present a complete trading system, but rather to present several concepts, and to illustrate theimportance of determining the major trend.

We start by opening an account with $300,000, kept in Treasury bills or in something liquid like a

"house" money-market fund. We move the funds to the stock account and back again accordingly. Theround-turn commission charge we will set at $700 per 1000 shares. Risk will be kept at a maximum ofapproximately 10% of capital. Purchases or sales will be done in 1000 share units. When we are stopped

out we will not usually reverse position, but wait for the next major signal. The exception is if the pointwe were stopped out at also shows a higher lo and higher high configuration or a lower lo and lower highconfiguration. We will be caught in two major consolidations, one bull market and one bear market.

Swing lows will be rounded down to the nearest whole number and swing highs rounded up to thenearest whole number on the chart.

We begin in the late fall of 1980. Homestake Mining declares a 3 for 2 stock split. Homestake is in thefinal stages of a spectacular bull market extending from a low of 35 in the late spring-early summer of1980 to a high at the 110 level in the late fall, six months later. The stock split goes into effect and

Homestake (HM from now on), makes a low at the 62 level. (Point A on the chart).

Since our swing chart only shows moves of $6 or more, in accordance with Livermore's principles, wehave to have a $6 rally from the 62 level before we can define 62 as an important "pivot point", as

Livermore called them. He used these "pivot points" to define major trend activity. HM rallies from the

62 level to 88 (Pt. A to Pt. B) and then has a decline exceeding $6. We now have two "pivot points"established at A and B.

If 88 is broken by $3 or more we will consider that indicative of uptrend activity. If the 62 level is brokenby $3, we will consider that indicative of a down trend. We wait.

HM rallies from 75 at C to 86 failing to break the 88 "pivot point." From 86, it turns lower again,approaching the newly defined, higher "pivot point'' of 75. We enter an order to sell 1000 at 72 stop ($3penetration). We sell short because this activity, breaking the 75 low, we define as "downtrend'' activity

and want to trade in harmony with that trend. HM drops to the 70 level. We are: short 1000 @ 72. Stopentered at 89, $3 above the last high. Risk: $17,700 including commission. (5.9%).

HM rallies from the 70 level at D to 85. Stop at 89 missed by $4. We classify this rally as a "natural

rally". HM then declines to the 78 level at F.Another rally takes place to 87 at E, within $2 of our stop.Notice also, not breaking 85 by $3, keeps the major downtrend in force.

HM has a sharp decline and we notice that if the 78 level at F is broken by $3, this further emphasizes the

downtrend in force and can be classified as "downtrend activity". We enter another order to sell 1000 @75. HM declines to 66. We are: short 2000 @ an average of 73½. Stop: 2000 @ 89. Risk: $32,400 or

10.8%.





HM makes a low at 66, then has a "natural rally" to the 77 level at G. From 77 another decline begins andwe move the buy stop down to 80, $3 above the last high of 77. We are short 2000 @ 73½. Stop: 2000 @80. Risk: $14,400 or 4.8%.

HM exhibits downtrend activity declining below 66. We have entered another order to sell 1000 @ 63.HM makes a low of 63½. Our price missed by ½ point. Another "natural rally" occurs to 71 at H. We

move the buy stop down to 74. We are short 2000 @ 73½. Stop 2000 @ 74. Risk: $2400 or less than 1%.

HM exhibits more downtrend activity breaking the 63½ low, where we sell another 1000 @ 60. We are:now short 3000 @ 69. Stop: 3000 @ 74. Risk: $15,000 or 5%.

The decline continues to the 50 level and another "natural rally" occurs to a high of 57 at l. "Downtrend"activity continues to a low of 45 near J, where we have sold another 1000 @ 47. We are now short 4000@ 63½. Stop lowered to 60 ($3 above 1). Risk: none.

HM rallies to the 61 level near 1, stopping us out of 4000 @ 60. Net profit: $11,200. Capital nowexpanded to $311,200. We do not reverse position, but wait for the next major signal.

Since we consider the major trend changed when 57 was broken by $3, we now consider HM to be

exhibiting major "uptrend" activity. A "natural reaction" follows from the 61½ high down to 55 at L.Then the "uptrend" activity continues exhibited by a rally from 55, but instead of breaking 61½ like it

should (if it is to continue higher,) it declines from 61 at K, just slightly under the 61½ high. Since thedecline down from 61 starts from a point within $3 but not higher than the 61½ high, we consider thisactivity indicative of a "secondary reaction". Our rule is that if a "secondary reaction" breaks back $6 or

more from the last high, we consider the major trend changing, and since this is the next major signalafter the 57 level was broken by $3, we sell short 1000 at 55 or $6 under the 61 high. We also enteranother order to sell another 1000 at 52 stop. HM declines to 53 at L. We are: short 1000 @ 55. Stop @

64. Risk: $9,400 or 3%.

From the 53 low HM rallies to 65, near K, stopping us out for a loss of $9,400. We now have working

capital of $301,800. And we wait for the next signal to occur. The rally to 65 at K, turns out to be abull-trap and HM swiftly declines to under 53, (the last low) indicating the major trend has turned lower.Since this is the next signal after we were stopped out at 64, we now sell 1000 @ 50, near M.HMdeclines to 46 and has a natural rally to 56 at N.

We are now: short 1000 @ 50. Stop @ 68. Risk: $18,700 or 6.2%. After the natural rally to 56 HM dropsto 50. Our stop is lowered to 59. We are short 1000 @ 50. Stop: 1000 @ 59. Risk: $9,700 or 3%. HM

then has another ''natural rally" to 58 at N, barely missing our stop @ 59.

From 59, HM begins another decline and we enter an order to sell 1000 @ 47. We are filled as HMdeclines to the 45 level near 0. We are now short 2000 @ 48½. Stop: 2000 @ 61. Risk: $26,400 or 8.7%.

HM has a "natural rally" to 53 at P, then turns lower. Stops now lowered to 56. We are now: short 2000@ 48½. Stop: 2000 @ 56. Risk: $16,400 or 5.4%.

We enter an order to sell another 1000 @ 42 as HM declines near Q. A swift bear market ensues with no

rally of at least $6 until the 18 level is reached near X. A "natural rally" occurs to 28 near R and anotherdecline drops HM to the 16 level, missing our order to sell another 1000 @ 15.

Stops have been moved down to the 31 level. We are: short 3000 @ 46 1/3. Stop: 3000 @ 31. Risk:

none. From the 16 low HM has another "natural rally'' to the 26 level near R. Then a $6 drop occurs to





the 20 level. From the 20 level HM starts to rally and we lower our stop to 29 and add an order to buy2000 @ 29 for the long account. We do this because we reverse position when there is a trendconfiguration of either a higher high and higher low or lower low and lower high. lf HM rallies to 29

from the 20 level, we will have this configuration defined. We buy 2 units or 2000 shares because ourstop can be entered at 17, so our total risk on the long side is $25,500 or 7.2%, after we take profits on

the 3000 short.HM rallies to the 36 level near S. We are stopped out of our shorts for a $49,899 profit and are long 2000@ 29. Stop: 2000 @ 17. Risk: $25,500 or 7.2% and our capital base has expanded to $351,699. Themajor trend is now up and a "natural reaction" occurs, dropping HM down to the 29 level.

From the 29 level, HM approaches the 36 top so we move stops up to 26 and enter an order to buyanother 1000 at 39 stop. HM rallies to 47 near U. We are: long 3000 @ 32 1/3. Stop: 3000 @ 26. Risk:

$21,099 or 5.9%.

From 47, HM declines to 41 exhibiting a "natural reaction". Another rally to 48 at U, and we move stopsup to 38. We are: long 3000 @ 32 1/3. Stop: 3000 @ 38. Risk: none. HM declines to 39, two points (but

not three) under 41, then rallies above 48 at U. We buy another 1000 @ 51 and move stops to 36. We arenow: long 4000 @ 37. Risk: $6800 or 2%.

The bull market continues to the 64 level near Z, exhibiting "uptrend" activity. A "natural reaction"

occurs to 54, and we move stops up to sell 4000@51. Risk: None. A further rally takes place from 54 upto a lower high at the 62 level. HM turns lower from the 62 level and since this is a reaction within 3points of 64, but not higher, we are ready to sell 4000 @ 56, which would be a S6 reaction from a

secondary top. HM declines to 47, turning the major trend lower for now. We are stopped out at 56 for aprofit of: $73,2000. Our capital base now stands at $424,899 for a total profit of $124, 899 orapproximately 30%. At no time did we risk more than 11% of capital. The 30% gain in two years is not

extraordinary, although at the time Livermore was trading, quite respectable. And we took no steps to usetools to fine tune any of our activities. Put the concept that it should be more profitable trading with the

major trend is illustrated. We also saw the helpfulness of defining price activity into categories. Lastly,we used basic principles of determining trend activity and saw them in action.

In summary, the purpose of this exercise was not to illustrate a complete and perfected system of trading,

but rather to illustrate the utility of analyzing price activity itself and to emphasize the importance oftrend determination as a foundation for any system employing technical analysis.


catalogue v 40

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