Learn from the world’s greatest ‘tape worm’ trader

Reminiscences of a Stock Operator is the autobiography of Jesse Livermore, one of the most colourful stock and commodity market speculators of his day. He operated in the early 20th century when technology was still quite primitive.

Back then, the ticker tape had just been introduced and speculators would ‘read the tape’ as it spewed out of the machine in much the same way as we pore over our screens. Avid tape readers were dubbed ‘tape worms’.

I’ve been re-reading this classic book and on almost every page there are nuggets of wisdom that traders can apply today. It’s one of the reasons this is often called the best book on trading – bar none.

Here is just one quote: “…my system for placing my bets… is simple arithmetic to prove that it is a wise thing to have the big bet down only when you win, and when you lose to lose only a small exploratory bet… if a man trades in this way… he will always be in the profitable position of being able to cash in on the big bet”.

That actually sums up my low-risk approach, my 3% rule and split bet strategy very nicely!

The book outlines Livermore’s journey from starting out as a novice to becoming a professional operator with all of the highs and lows along the way.

I cannot recommend this book highly enough – I try to re-read it at least once a year, and every time I do, I glean more insights than before. Today, I want to share some of those with you.

Don’t put the cart before the horse

One of the biggest early mistakes Jesse made was to take either a bullish or bearish view and then act on it with no objective trade entry or management system in place.

That is an approach that hasn’t changed in a hundred years! So many speculators believe that a study of what Livermore calls ‘general conditions’ (or the fundamentals) is enough to put them on the right side of the market.

Sadly, experience says that this is like putting the cart before the horse.

My approach is the opposite: determine the trend first and then act. The fundamentals will follow – if the trend is genuine.

One classic recent example is gold. Prior to October 2011, the fundamentals were pointing in the bullish direction. But then after the famous $1,920 top was in, the market fell heavily with no apparent change in the fundamentals.

It was only when gold was trading several hundred dollars lower that a new fundamental story emerged to seemingly justify the decline.

How to determine the trend

Here is a more recent case in GBP/USD. Recently, the economic news – Livermore’s ‘general conditions’ – have been bullish for the UK with employment, retail sales and GDP all positive. The market has naturally been in an uptrend with speculators flocking to the bull camp.

Here is latest commitments of traders (COT) data:

Non-commercial Commercial Total Non-reportable positions
long short spreads long short long short long short
(Contracts of GBP 62,500) Open interest: 202,115
Commitments
66,751 37,027 2,687 102,280 144,695 171,718 184,409 30,397 17,706
Changes from 03/18/14 (Change in open interest: -6,846)
2,610 -1,578 383 -7,165 -4,133 -4,172 -5,328 -2,674 -1,518
Percent of open in terest for each category of traders
33.0 18.3 1.3 50.6 71.6 85.0 91.2 15.0 8.8
Number of traders in each category (Total traders: 107)
37 23 8 28 30 68 58

 

Last week, both hedge funds (non-commercials) and small traders (non-reportables) reduced their shorts and increased their longs. That means they now hold approximately two longs for every one short.

As I have documented for a long time, it is when most traders have flocked to one side of the boat that it is in danger of capsizing. I am always on the lookout for this kind of event, because it can provide a very swift and profitable move in the opposite direction.

Here is the daily chart showing the long-established wedge pattern I have been following:

GBP/USD spread betting chart

The upper line has several accurate touch points with the stand-out overshoot above 1.68 on 17 February. This marked the high (so far) and is characteristic of overshoots, since they often signify a buying exhaustion.

The lower line also has many accurate touch points, marking it as a significant line of support. Breaking this line would likely produce a cascade of selling, which is what I am looking for. The wedge has contained all trading over the past six months, and so a break would likely be a major event.

Also of note is the gradual weakening of buying pressure indicated by the long-lived negative-momentum divergence.


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What to do when the trend is changing

The overall trend remains up, but that trend seems to be weakening in preparation for a trend change. So with this background, how can we play this?

Here is the hourly:

GBP/USD spread betting chart

The move off the 1.68 high can be said to be an A-B-C correction (green lines), implying the main trend remains up. But the rally off the 23 March low has carried to the Fibonacci 62% retrace – a typical reversal point for a correction.

So there is a tug-of-war going on now between these opposing forces.

Let’s now take a closer look on the hourly:

GBP/USD spread betting chart

I have drawn in a major line of support/resistance. Note the alternate regions of support and then resistance of this line over a two-week period.

I am calling this my ‘line on the sand’. Note that it runs parallel to my lower wedge line, making a neat tramline pair!

In the last few days, this line has held all attempts to break down through it. But a downward break would be significant. There are bound to be many sell-stops placed there by the bulls (who out-number the bears by about two-to-one).

If the market can break down from here, it would be a major event. But unlike the early Livermore, it is best to wait for the market to tell us what it wants to do – and then act. That is putting the horse before the cart – and it will have you off and running in the right direction.

• If you’re a new reader, or need a reminder about some of the methods I refer to in my trades, then do have a look at my introductory videos:

The essentials of tramline trading
Advanced tramline trading
An introduction to Elliott wave theory
Advanced trading with Elliott waves
Trading with Fibonacci levels
Trading with 'momentum'
Putting it all together

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