In Chapter 2 of How To Trade In Stocks, famous speculator Jesse Livermore discusses how to determine when a stock is acting properly and how to react to a stock that begins showing danger signals. Livermore explains that each stock has its own character and its own personality
Each stock has certain traits and behaves a certain way in different situations. Your job as a speculator is to get to know your stock well enough to know whether a given move fits the standard of how your stock generally behaves.
Once you understand how a stock’s price and volume action normally works, you will be able to identify when the stock makes abnormal movements. These abnormal movements can be signals that the stock is about to change its personality.
Abnormal Moves Can Signal Danger Ahead
“You have had patience to stay with the stock all during its natural progress. Now have the courage and good sense to honor the danger signal and step aside.” – Livermore
One of the toughest things to learn about speculating is the ability to read these danger signals and the courage to close out a position because of them. Livermore explains that human nature works against the speculator here encouraging him to ignore the danger signals and to hesitate when he should be closing out a position.
He goes on to argue that this human nature is the greatest enemy of the average speculator. If we are going to be successful at extracting money from the financial markets, we are going to have to learn how to operate independently of our nature. Livermore also explains that human nature causes us to feel that we always need to have an interest in the markets.
“one cannot be successful by speculating every day or every week; that there are only a few time a year, possibly four or five, when you should allow yourself to make any commitment at all.”
This is a very foreign concept to those people talking about the markets on cable TV. According to them, you should be invested in every stock, mutual fund, and commodity out there at all times.
According to Livermore, you only need to make a few big trades per year to be successful. He also argues that if you do your homework correctly, any trade you make should show you a profit from the very first day. He explains that those people who feel like they have to trade every single day are the ones laying the ground work for the major market moves that we will seek to profit from.
Livermore goes on to explain that because these people are so busy trading day in and day out, they lose site of the major market moves. This is the classic case of not being able to see the forest because of all the trees.
California Mountain Trader
Livermore continues this thought by describing a very successful speculator he had heard of who lived in the mountains and traded only a few times per year based on data that was three days old. The man explained that living in the mountains gave him the bigger perspective he needed to trade the long term trends without getting lost in the short term noise.
This long term trend perspective is where we will find our best chance to book impressive returns.