Trade Stocks Using the Livermore Method

08/21/2015 6:00 am EST

Focus: STOCKS

For the benefit of anyone new to trading stocks, Adam Lemon, of DailyForex.com, outlines the stock trading method of a man who was probably the greatest stock trader of all time—Jesse Livermore—and Adam highlights which of Livermore's broad methods are still just as relevant today.

Although I am a forex trader, I have to admit that there is probably more money to be made in trading stocks than there is in forex, although it is just a question of degree. One of the most successful stock traders of all time that ever lived is Jesse Livermore. He explained his trading rules in two books, but as there were discrepancies between the two publications, there is a lot of confusion over exactly what his methods were. After careful study of his writings, I will outline here the broad methods that he used and which can still be used today to achieve spectacular profits.

One word of warning first: when Livermore traded stocks as a serious professional, he bought and sold the stocks themselves on a 10% margin. This is quite different to most of today’s online brokers that allow trading in individual stocks. To do this properly and without paying far too much in fees and commissions, you really need to start with a five-figure sum and use a top-of-the-range broker.

Here is how Livermore did it:

Step 1—Determine Whether the Stock Market Is a Bull Market or a Bear Market

Livermore explained that he did not start to become a real professional until he learned to anticipate big market movements. One of the advantages of trading stocks is that you can use the wider economic cycles and conditions to predict whether they are more likely to broadly rise or fall.

There are several statistical definitions of what constitutes a bull market or a bear market. Traders can also look to economic fundamentals to confirm whether a bull or bear cycle exists. Perhaps the easiest method is to use some fairly simple technical analysis of the major stock index itself, with the most significant of all global stock indices being the S&P 500 (SPY) (SPX). Moving averages are most commonly used: for example, if the 50-day simple moving average is above its 200-day equivalent, a bull market can be called, with the converse signifying a bear market. Alternatively, you might want to look at whether two consecutive months close above or below the 12-month simple moving average to determine the same.

When you trade stocks using the Livermore method, you only go long during a bull market and short during a bear market.

Step 2—Prepare to Open New Trades When a New Bull or Bear Market Begins

Livermore stated that a stock trader’s job was to begin buying stocks right at the start of a bull market and hold on until the bull market was over, or to begin short selling stocks right at the start of a bear market and hold on until the bear market was over. He also pointed out that sometimes a market is not quite bullish and not quite bearish, which would mean time to get out of existing trades but not time to open new ones in the opposite directions.

Step 3—Sector Selection

When the trader is ready to start going long or short, they must decide which stocks to buy. Stock indices can be bought, but profits can be maximized by picking the hot stocks of the coming cycle. This is best achieved by a top-down approach that looks at sector indices which are published by several financial services companies. Of course, studying the economic situation of that sector can be helpful as well. Technically, you can look at the prices of the sector indices and see whether they are also looking as bullish or bearish as the wider market index, which is an important confirmation that you are looking within the right sector.

NEXT PAGE: Buying Breakouts and Selling Breakdowns

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Step 4—Stock Selection

Livermore traded the two hottest stocks from each selected sector that he wanted to be in. Again, a simple technical method of seeing which stocks are making the strongest new highs or lows can be used, in addition to studying the companies’ financial data, market share, products etc. There were two major advantages of being in the two hottest stocks of a sector: firstly, a benefit of diversification and secondly, Livermore saw that if one of the stocks started behaving significantly worse than the other stock, this was a likely indication that something was wrong with that company, and when that happened, he would get out of that stock.

An important part of trading stocks using the Livermore method is focusing on key companies that are at the forefront of technological change and customer demand. Livermore focused a lot during the early part of his career on sugar, steel, and railways, which were key components of the economic changes during the late 19th century. During the current bull cycle it is certain he would be buying Apple shares in the same way he bought sugar when new technology was being developed to make sugar affordable to the masses.

Step 5—Making the Trade

Livermore liked to buy breakouts and sell breakdowns. He also always scaled into his new trades and not in equal position sizes either. I can illustrate this with an example.

Suppose you have identified the start of a bull market. You are interested in stocks A and B within sector C. Stock A makes a new high price, higher than it has been for several weeks or months. Livermore would buy stock A immediately, but with only one quarter of the total amount of shares in that stock that he might eventually buy. He would then wait to see how it acted. If it continued to rise strongly and make new highs, he would buy again—half of the remaining three quarters—and then wait some more time. If the pattern repeated itself, he would then buy the remainder of the shares that he wanted. He did say that you could use a 1% rise in price as a signal to add to the trade, but he probably used his own judgment more than he used any set percentage.

If at any time the move up seemed to fail, Livermore would get out. By scaling into the trade, he protected himself from more severe losses when he was wrong about the momentum of the move. When he was wrong, he would patiently wait until everything looked right again and try the trade again.

Livermore did not use hard stop loss orders. He just got out when he judged himself to have been wrong.

Step 6—Sitting Tight

One of Livermore’s most famous quotes is, “I made more money by sitting tight than I ever did by being right.” What he meant by this was that nobody could foresee every market swing, so get in at the beginning and don’t get out until the whole market has played out. In this way, you might buy a stock for $10 and sell it two years later at the end of a bull market for $210 and make huge profits. He warned specifically about selling on pullbacks out of fear the market was turning and then trying to buy the shares back later. Livermore suffered from this in his early years of stock trading.

Conclusion

There you have an outline of the stock trading method of a man who was probably the greatest stock trader of all time. One final word of warning: Livermore went bankrupt several times and this was due mainly to his poor money management skills. He simply risked too much of his capital on his trades. Be careful that in this area, you do not follow his example.

By Adam Lemon, Contributor, DailyForex.com

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