Lessons From Livermore’s Reminiscences – Part 1

One of the finest books ever written on the art of trading and speculating is Reminiscences of a Stock Operator by Edwin Lefavre. Though written as a pseudonym, this is a great descriptive account of one of the greatest traders that lived. The book is so full of nuggets of wisdom that one would get lost keeping count of the same. It is a must-read book for anyone who is serious about trading and speculating in the market. It resonated within me because, just like Livermore, I started with only a few coins and notes in my pocket. So what he said and experienced was both very reassuring as well as inspiring lessons for me . I had this yen for price action right from the start of my career in the markets, I recall, and I guess that is what drew me towards the book since it lays tremendous emphasis on the way prices ought to “behave”- a point that Livermore makes many times over. Even into today, my reading of the market is all about how it behaves given the various news and events that surround it and this instinct, I suppose, was burnished by repeated readings of this all-time classic.

Recently I started reading the book (possibly some ninth or tenth time) and I felt I just had to put some of the important lessons as I have experienced them in the market. There are so many lessons that one can get from the book that I propose to make this into a series. So here goes with the first part. Each part will carry at least a couple of lessons (depending on how much I have to add to that point or experience).

Lesson no 1: Prices change. Why? Don’t care.

If there is one thing to take lessons from the market it is that prices never stay still. They keep changing in response to constant change in supply and demand. They change in constant response to people changing their minds about what is cheap and what is expensive. They also react to when people change their minds about what looked cheap but are now no longer so (even though the price is lesser!). The reverse of this also true- when prices move higher, people change their minds about what they thought was expensive and decide to buy higher!  This is a very paradoxical way that we view market prices compared to anything else we do in normal life.

Now it is very, very difficult to know what or where or when people will change their minds about what is cheap and what is expensive. But the action as a result of that changed decision is always the same- they have to either buy or sell.

And when they do that- the prices have to move. No choice about it. The more the number of people who act on what they think the more the prices change.

Now the problem has always been that people always want to know Why? The more intelligent the person, the greater the need to know the reason for the change in price! Most people cannot even move to take action unless they know the reason. They would much rather let the opportunity pass.

The problem is more acute as the time frame of the trade drops, becoming maximum in intra-day trades. There is a sudden movement either up or down and the trade probabilities change suddenly. Very few act. Instead they hit their Whatsapp, they hit the phones, they turn on sound on the TV (from mute!) or they stare at the screen (hoping that the prices would go back to where it was). Do anything but act.

I have been there, done that. Not once but many, many times. Even into today. The thing is, your rational mind has such a firm grip on you that it is difficult to let go and act. But that is just what is needed. This is what an algo or a machine does. As soon as probabilities for the trade change (the stop loss being one of those signals), the algo kicks in and takes you out of the trade. But your mind won’t do it- because it wants a reason to act. Many times such hesitations have led to larger than anticipated or planned for losses.

There shall be a few occasions when the delay in acting actually saved you from a premature entry and then the trade went into profits. The mind tends to remember only such occasions and conveniently overlooks the countless times that quick action save you from further losses. The reason the mind overlooks this is that such trades were the ones you were wrong but the few that went the other way were the ones that you were right! Your mind plays tricks with you all the time in the market. Be aware of it.

Hence the best advice (Livermore states this almost at the start of the book) is Don’t question the price change. They change for a reason. There is absolutely no earthly reason why you should get to know. In the meantime the prices are doing what they are supposed to be doing. Are you? Here is how Livermore sums up this lesson: Of course there is always a reason for fluctuations, but the tape does not concern itself with the why and wherefore. It doesn’t go into explanations. I didn’t ask the tape why when I was fourteen, and I don’t ask it to-day, at forty. The reason for what a certain stock does today may not be known for two or three days, or weeks, or months. But what the dickens does that matter? Your business with the tape is now—not tomorrow. The reason can wait. But you must act instantly or be left.  I think that says everything that needs to be said.

Lesson 2:  Acting on a Tip

Livermore has this great account on his first-ever tip in the market. And explains in detail what he did with it. This has been a good lessons for all of us. It is something that I have practiced diligently all my life and I have only been richer for this practice.

Early in his career, a friend of Livermore walks up to him and asks him to for money to invest in a tip. Livermore asks him how he is going to play it and the friend tells him the process and promises that they would double their money in no time. Here is what Livermore writes, “I wasn’t interested in doubling my money, but in his saying that Burlington was going up. If it was, my notebook ought to show it. I looked. Sure enough, Burlington, according to my figuring, was acting as it usually did before it went up. I had never bought or sold anything in my life, and I never gambled with the other boys. But all I could see was that this was a grand chance to test the accuracy of my work, of my hobby. It struck me at once that if my dope didn’t work in practice there was nothing in the theory of it to interest anybody. So I gave him all I had,”

See the main point here- he starts by saying he was not interested in doubling his money! This is a phenomenal statement. It takes the focus instantly away from the outcome. Instead, he focuses it on the process by saying that his ‘dope book’ (which is one of the horseracing terms frequently found in the book) has to reflect the same! This clearly shows that we should rely purely on our own research of something rather than blindly believe what someone else says. It also states indirectly that you must have done the research to fall back upon!

How many of us really do good research on stocks that we are interested in? Just a couple of days I was speaking to someone who had fallen a victim to one of those phone tip frauds. It is amazing how people will fall for such schemes. They fully deserve the losses they get. See, tips are good if the ‘tipper’ is someone who does research himself and you are relying on that.  But mostly, we rely on tips because we either are too lazy to do the work or we don’t know how to do it. Neither is an excuse. There are plenty of places where you can get trained on what to do. It is your responsibility to do it. A lazy trader will always get parted from his money sooner or later.

Next notice what he says about his own research- it is a grand chance to test my theory, he says. Clearly, even though he did the work, he needed proof of it working.  The biggest problem with analysts (or people who do some analysis) is that they think they now know it all. The market MUST do what their analysis says!

Some of my biggest losses have been great lessons from this fallacy- thinking that my analysis was so correct that I could not think of any other possibility. I remember shorting an illiquid stock once because it was supposedly doing a ‘three of three’ (my Elliot wave reading) and I felt I couldn’t lose and I was actually going to clean up (because this is the best wave to trade). It was one of the biggest losses I took and big lessons. Being an illiquid stock, the main buyer just lapped up whatever was available at that time and I had to run from pillar to post to cover the short. I will never forget that incident as it was a big lessons for me . It taught me never to overestimate the value of what I have done. The market is much, much bigger than what you or I can throw at it.

Since I speak to a lot of people every day, there are scores of tips that I receive. But without clearing them with my charts and my study of the scrip’s background I seldom invest or trade in any of them. If I can’t find the details on it, I study it for several days to see how it ‘behaves’.  The stock needs to show the kind of behavior pattern that is consistent with a bullish or bearish view. If that doesn’t happen then I pass on the tip, no matter who it came from. I may have lost out on some good deals but I would think that it has saved me from countless number disasters. An example would be a tip I got on a Hospital stock some 5 years ago. It was at 170 back then and all kinds of positive stuff were to happen. Big guns of the market had taken a position in it. This friend of mine had taken a truckload of stocks and was urging me constantly to buy. But try as I might, I simply couldn’t find the stock ‘acting’ right on the charts.  So I desisted. In and thru the past five years, the “news” is still intact but prices first went to 100 and are now back at 180 levels.  So much for tips. Another recent example is a telecom stock that is being pushed similarly on the back of a great deal of buying from market mavens and possible resolution of their problems (which are plenty).  It’s been two years and the stock hasn’t moved a centimeter.

Finally, look at the last part of Livermore’s action- So I gave him all I had.  This is a great lesson on position sizing without stating as much. Once he had convinced himself about the viability of that tip on Burlington, Livermore decided to give it his all.  He had the research and it said Go and so he Went! All in. And made a bundle (all of $3.12m, he writes- remember this is 1903 he is talking about).

Here is another big error we all make. We do the work; satisfy ourselves that it is a good one, plan out contingencies too. Then we go and put on a small position. Let’s say you saw an opportunity where a stock is going to move 400-500 points and it is in the FnO space too. Its options trade actively too. You now have a choice of buying a hundred shares or two on delivery. Or you could buy more in Futures. Or you could bang it harder with long Calls.  Your duty is to extract the max out of your analysis and views. Instead, if you go and put on a small position, you will win all right. But did you play it to the potential that trade offered? No.  Under-trading is as much a crime as overtrading which are lessons to be noted.

We are guilty of this most times. In hindsight, we often tell ourselves that we should have killed it. But the time comes and passes away. Full focus on each aspect- that is what Livermore is saying here. First check your research if the stock passes muster and then if it does, play it with the correct position sizing. This is one of the most important lessons. Understand that this are lessons and practiced to make it part of our persona. I still fumble at this after so many years at it. Our mind, our surroundings, our recent experiences, etc. all combine to create our mindset. At the time of the trade, we must learn to focus purely on it and, like Livermore says, give it all we got!

Until the next time, in part 2.