Friday, February 18, 2011

Jesse Livermore's Trading System

Best Financial Markets Analysis ArticleA butcher never chops with a blunt knife, yet it is common to see a trader operates with an unsound trading system. The fastest way to get a winning system is to steal one from a successful trader, and for that matter, there is no better candidate than legendary trader Jesse Livermore, because his method was very simple: it contained only three components, which are respectively known as the reversal pivotal point, the continuation pivotal point, and the symptoms of weakness. Their application would be explored in this article.

1. Reversal Pivotal Points

The first component of Livermore’s system is the reversal pivotal point, which is defined by Livermore as “the perfect psychological time at the beginning of a new move, representing a major change in the basic trend.” However, confirming a market turn in real time is not easy, e.g. when there is a rally in a long bear market, how can you tell whether it is just temporary, or the bull market has returned? You can use the following four steps to justify:

1. The bear market rally does not get retraced below its starting point. 2. Within two weeks after the initial rally, an even bigger rally follows. 3. The volume of this subsequent rally is significantly higher than previous days. 4. This subsequent rally usually breaks the trend line of the previous bear market.

This monumental subsequent rally is exactly what Livermore called a reversal pivotal point, because it marks the return of large investors into the market, and although the market often corrects on furious volume immediately afterwards, it usually rebounds soon and begins a new trend.

2. Continuation Pivotal Points

The second component of Livermore’s system is the continuation pivotal point, which concerns the time to enter the market. While a reversal pivotal point marks a trend reversal, a continuation pivotal point confirms that the trend continues.

According to technical analyst R. N. Elliott, a trend is composed of impulsions and corrections: whereas impulsions are the parts in which the price drifts rapidly with the trend, corrections are the consolidation parts in which stocks are accumulated before the market takes off again, and this breakout from consolidation is known as the continuation pivotal point, where a trader should get in and follow the trend.

Stock expert William O’Neil believed that buying at continuation pivotal points is one of the greatest secrets in trading stocks, because the price seldom falls for more than 10% after a genuine breakout. Therefore, the primary job of a trader is to recognize a genuine breakout from consolidation, to identify which O’Neil listed out three clues to look for:

Clue 1: A Sound Pattern:

The consolidation is usually in the form of a sound chart pattern. The most common pattern, according to O’Neil, is the cup-and-handle formation, where the price forms a concave shape of a bowl (the “cup”) with a small pullback at the end (the “handle”). Patterns formed within seven weeks are usually weak and should be considered carefully. Limited by the size of this article, please refer to How to Make Money in Stocks by William O’Neil for more discussion on chart patterns.

Clue 2: A Tight Accumulation:

A good breakout depends on the “tightness” of the accumulation (e.g. the “handle” part of a cup-and-handle). If the consolidation has a narrow day-to-day change relative to the weekly range, it is then considered more reliable than a “wide and loose” one.

Clue 3: A High Volume upon Breakout:

Most importantly, just as for a reversal pivotal point, a true breakout at a continuation pivotal point is usually accompanied with a higher volume than the previous few days.

3. Symptoms of Weaknesses

The last part of Livermore’s system is called the symptoms of weakness, which concerns the question of when to exit. As Baron Rothschild had allegedly said, “I never buy at the bottom and I always sell too soon.” The best time to sell is upon the signals of trend exhaustion when the following symptoms of weakness appeared in the market:

Symptom 1: Head-and-Shoulders

William O’Neil pointed out that head-and-shoulders are the most common pattern in a topping market, where the peak of the market (the “head”) is surrounded by two lower peaks (the “shoulders”) on both the left-hand and right-hand side respectively, especially when the right shoulder is lower than the left shoulder. Sometimes, the market will perform what is known as a “head test” when the price rebounds immediately after the right shoulder is formed, and tests the “head” level of the pattern before falling again. Examples of the head-and-shoulders pattern are the Dow in August 1987 (without head test) and in July 1976 (with head test).

Symptom 2: Period of frequent distribution days.

The distribution day is a highly accurate weakness signal, especially if preceded by a successful rally. A distribution day is where the large investors unload a part of their shares under the perception that the market is topping out. A distribution day is best characterized with a wide high-to-low spread and a heavy volume, but it never closes too much higher than the previous day. In addition, it usually has a small open-to-close difference, a shape known as the “doji” by candlestick experts. When you see a lot of these days in a period of modest momentum, it usually means that the trend is probably over.

Symptom 3: Failed rallies.

The last sign of a topping out market is that, after an overall head is formed, the subsequent rallies often end with a weak momentum, as demonstrated by a diminishing increase in price accompanied by a decreasing volume, and each day the close is usually away from the intraday high. This is a sign that the large investors are not very keen in buying the pullbacks.


Over his legendary career, Livermore obtained two important insights in trading: firstly, he often lost when he entered a position before a pivotal point was formed, and secondly, the big money could only be made by capturing big trends, thus he developed the discipline to avoid any personal opinion until a pivotal point appeared, as well as to hold onto his positions until he was shown the symptoms of weakness. In short, this is how Livermore traded:

1. Trend confirmation: he never trade against the trend as indicated by the reversal pivotal points. 2. Careful entry: He only entered the market when a sound breakout appears. 3. Let the winners ride: He held onto his positions until the symptoms of weakness appeared.

And you are very unlikely to be doomed in trading if you follow these rules.

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Victor Chan Wai-To is a currency trader based in Hong Kong.

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