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Newsletter April 1, 2006 Richard Smitten's observations on Jesse Livermore Market & Sector Review How Are You Doing? Largest Changes This Week This Week's Economic Reports Beginning April 7 through April 14 our family will be away, enjoying a well deserved vacation. The Prudent Trader site will be updated this coming week April 3 through April 7, however, there will be no updates the week of April 10 thru 14, an email will be sent to members upon the first update after our return. The next newsletter will be April 22, 2006. Richard Smitten's observations on Jesse Livermore In his book "How to Trade Stocks" Richard Smitten talks about Jesse Livermore the man and his trading techniques (Available from Traders Press). Here are some of his observations about the legend Jesse Livermore. He quickly learned that it was never what the brokers, or the customers, or the newspapers said — the only thing that was important was what the tape said. The tape had a life of its own, and its was the most important life. Its verdict was final. He learned to be interested only in the change in price, not the reason for the change. He had no time to waste trying to rationalize the action of the stock. There could be a million reasons why the price had changed. These reasons would be revealed later, after the fact. He knew that unless he actually purchased a stock, he could never know how he would handle himself. When a trader made a bet everything changed, and he knew it. Then and only then did the trader enter the heated jungle of emotions.. .fear and greed. You either control them or they control you. He worked alone.. .never telling anyone what he was doing, never taking on a partner. The trill came from the winning, not the money, though the money was nice. He never blamed the market. It was illogical to get angry at an inanimate object, like a gambler getting mad at a deck of cards. There was no arguing with the tape. The tape was always right; it was the players who were wrong. His first conclusion was that he won when all the factors were in his favor, when he was patient and waited for all the ducks to line up in a row. That led him to his second conclusion, that no one could or should trade the market all the time. There were times when a trader should be out of the market, in cash, waiting. To speculate, a trader had to be a player, not a theorist, or an economist, or an analyst. A speculator had to be a player with money down on the table. It was not the coach or the team's owner who won the game, it was the players on the field — just as it was not the generals who won the battle, it was the grunts on the ground. You had to lose, because it taught you what not to do... his conclusions were developing from actual trading, from hands-on participation in the market and constant analysis. He never used the words bull market or bear market because these terms tended to make too permanent a psychological mind-set. Livermore was looking for the difference between stock gambling and stock speculation. Livermore's final conclusion was clear: To anticipate the market is to gamble; to be patient and react only when the market gives the signal is to speculate. The first step was to concentrate on the overall market before making a trade. He would follow the line of least resistance— up in a bull market, buy long, down in a bear market, sell short. If the market went sideways, he would wait in cash for a clear direction to be established.... He would not anticipate the market by guessing its direction... .Livermore had come to realize that the big money was in the big swings... .it is the big moves that make the big money. Livermore believed that stocks are never too high to begin buying or too low to begin selling short. Livermore believed that there was only one side of the market to avoid. He could be on the bull side or the bear side — it made no difference to Livermore — just as long as he was not on the wrong side. From experience, Livermore knew that one of the hardest things to do as a trader was to sell out a position early if he was wrong on the initial purchase and the stock moved against him. He did not care why things happened in the market, he cared only what happened every day when the market opened.... He observed that the market always did what it wanted to do, not what it was expected to do. Livermore had a steadfast rule that if something serendipitous, an unplanned windfall, should occur, he must capitalize on it and not be greedy — accept his good fortune and close out his position. Livermore loved the fact that in trading the market there was no end to the learning process. The game was never over, and he could never know enough to beat the market all the time. The puzzle could never be solved...he never considered himself a market master. He always considered himself a market student who occasionally traded correctly. Livermore had long ago realized that the stock market was never obvious. It was designed to fool most of the people most of the time. His rules were based on thinking against the grain: cut your losses quickly; let your profits ride unless there's a good reason to close out the position; the action is with the leading stocks, which change with every new market; new highs are to be bought on breakouts; cheap stocks are often not a bargain, because they have little potential to rise in price. The stock market is a study in cycles. It never goes up forever, nor does it go down forever, but when it changes direction it remains in that new trend until it is stopped. He considered it necessary to act like a poker player in his business, to never tip his hand or to react emotionally. Because of this inability and unwillingness to express his emotions, the stress on him was permanent. Timing was everything to a speculator. It was never if a stock was going to move; it was when a stock was going to move up or down. Livermore always considered time as a real and essential trading element. He often would say it's not the thinking that makes the money — it's the sitting and waiting that makes the money... .This has been incorrectly interpreted by many people to mean that Livermore would buy a stock and then sit and wait for it to move. This is not so. There were many occasions where Livermore sat and waited in cash, holding little or no stock, until the right situation appeared. He was able to sit and wait patiently in cash until the perfect situation presented itself to him. When conditions came together, when as many of the odds as possible were in his favor, then and only then would he strike. Livermore let the market tell him what to do, he got his clues and his cues from what the market told him. He did not anticipate, he followed the message he received from the tape. It's scary to think how much money Livermore would make if he traded today.. .his ability to read the tape when the tape wasn't even that reliable. He is in our opinion the best ever. Since the market is an extension of human psychology and human emotion and because people don't change, the market doesn't change. The players change; the underlying issues change; trading doesn't change, and that's why over 60 years after he committed suicide, Livermore's words of wisdom are still relevant. Market & Sector Review How Are You Doing? It might be human nature: but many investors and traders seem to be more interested in their performance when the market is rising. I believe it to be more important to analyze your performance on a periodic basis, i.e. quarterly or semiannually. Are you on track to meet your objectives: if not why not? Did you change something in the most recent quarter such as your time frame, your methods, or your goals? If you did is it working as planned? Since we have just completed the first quarter of 2006 this is a good time to review your trading. Whether you are a new trader or one who has been at it for decades you will someday come to realize that you never, ever, stop learning in this business. There is no "holy grail" or system that works in all market environments, we must continue to learn not only from our mistakes but from what we did correctly. While I do not believe it is a good idea to dwell on your most recent trade it is an outstanding idea to keep notes with each trade and then periodically go back and review not only your trades but your notes as well. This is the only way that I know of that you will learn about yourself, about differing market conditions, and what possessed you to do what you did; right or wrong. Most traders have a tendency to measure there performance versus a benchmark average as if they were a money manager whose bonus this year depends upon their performance versus the benchmark. If the S&P 500 is up 10% and I am up 12% then I am fine. What about the converse; if the S&P 500 is down 20% and I am only down 18% Am I still fine? While you may think so; I think not! Try and remember the first rule of trading is not what some indicator or pundit says. The first rule of trading is or should be; "Preservation of Capital". Most often the charts, the indicators, the fundamentals are ambiguous. Don't attempt to force a trade, stand aside and wait for your conditions and outlook to be clear before you move. Even when things are clear and your outlook appears correct there is still risk involved. Wouldn't it be better to say the S&P is down 20% and I'm only up 2% or just down 2%? Instead of measuring your performance against a benchmark index, measure it against your goals. When I used to coach newer traders one thing I always insisted on, was notes detailed notes. When you buy XYZ in addition to the date and price, write down your initial stop (risk, exit strategy) and your objective. Then proceed to write a detailed reason why you just purchased XYZ for example: strong relative strength ranking, emerging or strong group and sector; chart pattern; market looks higher to me (why?); how you feel (this trade scares me to death); and so on. When you exit the position do exactly the same thing. Below is a picture of what I mean, the first quarter trading of someone who is fairly happy with his results in a difficult market, although he feels he could have accomplished more (my kind of attitude). I have reduced his notes to fit on the picture; they are a great deal more detailed. Hopefully you will get the idea. In the sake of privacy I have removed the company names, symbols, and share amounts. You would think that someone who had a decent quarter would not bother to go over his record at this point, however it's just as important as if it was a down quarter. He will, probably this weekend, go back over these trades, the charts, and his notes to see what he might have done differently to maximize his return. In that look back he will notice something different that was not apparent to him at the time. He will learn from not only his mistakes but from his victories as well. I should note that just because there was a loss on a trade does not necessarily mean that you would not repeat that trade under similar circumstances. The loss could have been the result of an extraneous factor not foreseen and not likely to repeat. Make detailed notes; learn from your trading history, it's the only way! I believe it was Sy Harding who coined the phrase "Sell in May and go away". On Thursday the New York Stock Exchange Index made yet another new all time high, yet had the fewest number of new highs than at any other new high. Last September the NYSE made a new high at approximately 7,600 accompanied by about 300 new 52-week highs. January 2006 saw another new high at approximately 8,100, again with about 300 new 52-week highs. Late February we saw yet another new high at 8,150 with 280 new highs. Then again this past Thursday we saw another new high at 8,322 but now under 200 new highs. Notice also that the McClellan Oscillator dipped below zero and the McClellan Summation Index did not move much at all. In other words the internals of the market are continuing to deteriorate. That being said I believe we have more upside before any serious decline. Why? Simply stated the NASDAQ has begun to outperform and usually when the NASDAQ outperforms the market is OK at least for awhile. This is precisely why I pointed to the NASDAQ-100 and a few components two weeks ago as a low risk trade. Either the NDX was going to pull the entire market lower or it was going to participate. Now it is leading and as long as it leads we are in all probability OK. I will be watching primarily two factors to determine market direction in the short term: 1)IBD's Distribution days as outlined on the chart above; and 2)If the NASDAQ and NASDAQ-100 gives up its current leadership. The coined phrase above "Sell in May and go away" may just turn out to be very sage advice indeed. This market may just continue to work higher until then. Largest Changes This Week This Week's Economic Reports Have A Great Week! Bill Disclaimer: Trading in securities, of any type, may not be suitable for all individuals. The contents of this newsletter are not a solicitation to buy or sell securities. The opinions expressed are solely that of the author. You must do your own research, contact your own financial advisor for suitability of any investments. Data gathered is from sources believed to be reliable, but NO guarantee as to their accuracy is made.