Before Mastery - Chop Wood Carry Water
After Mastery - Chop Wood Carry Water
Anonymous Zen Master
Speculative markets can be described as continuous auction markets and as clearinghouses for the latest supply and demand information.
The meeting places of buyers and sellers, the Stocks and Futures market today include an ever-expanding list of commodities such as: agricultural products, metals, petroleum, and financial instruments, foreign currencies and stock indexes not to mention ~6000 common stocks.
Interesting fact is that major patterns in the market do no change. This is mainly driven by the human element of fear and greed. The techniques Jesse Livermore used to analyze the stock market is as valid as ever. The trend following concepts and swing trading ideas of his market system is also valid today.
The basis of the Livermore system bears similarity to the wave theory. (I never studied or gotten too much into Elliot’s school of thought due to my laziness. The similarities are actually superficial.
How to Trade In Stocks
How to Trade in Stocks was copyrighted in 1940 - the year Livermore died. It is believed that he wrote the book in a desperate attempt to raise capital.
The book talks about the rationale of Livermore's decision-making process while trading.
Its ten chapters are:
I. The Challenge of Speculation
II. When Does a Stock Act Right?
III. Follow the Leaders
IV. Money in the Hand
V. The Pivotal Point
VI. The Million-Dollar Blunder
VII. The Three Million Dollar Profit
VIII. The Livermore Market Key
IX. Explanatory Rules
X. Charts and Explanations for the Livermore Market Key
In this book we focus on the inherent logic and code of the system. Many earlier issues chapter IX and X are missing due to some unscrupulous characters whom tried to keep secrets from the general public. Even when these chapters are present the full understanding of Livermore's system one needs detective work and some amount of speculating to grasp the meaning of the Market Key.
I believe in no secrets when it concerns a public domain subject that is so huge and so important. I can’t understand how someone believed that the truth could be suppressed.
Livermore places the markets in certain states;
- Up Trend
- Natural Rally
- Secondary Rally
- Down Trend
- Natural Reaction
- Secondary Reaction
The system also determines a number of pivot points as defined by Livermore, the names of the corresponding variables used in the program are in parenthesis
- Peak up Trend Price (UpTrend)
- Peak Natural Rally Price (NaturalRallyBL)
- Bottom down Trend Price (DnTrend)
- Bottom Natural Reaction Price (NaturalReactionRL)
- Key Price (requires two stocks, logic not included)
State diagram of the Market Key (next page)
The above figure measures the state of each bar using the values recommended by Livermore
The following figure depicts the state of each bar using an ATR threshold.
The states “Natural Rally” and “Natural Reaction” are inherent corrections to bull markets. Livermore states in his writing that a reaction in a bull market is welcome and natural as breathing fresh air. It does several key things;
If it is early enough it lets in latecomers to the market who for some reason had missed the rally. It ‘sorts out’ the weak hands from the strong hands. Many impatient and undercapitalized traders get out too soon only to panic and return later only to further fuel the rally.
The market needs to settle and get ready for the continuation if that is to come.
The limitations of the Livermore system as is
As to this day I am testing and found only the 6 points and percentage (non-original setting) working with the stock market. Futures testing (on S&P ten-year data) so far proved to be losers. The fixed six-point setting is fine when the stock price above 30. I am testing with historical data that has lower prices (as early as 1988) and a dynamic percentage method is best.
In Livermore’ s days stock operators worked on a 10-percent margin. So when Livermore states 6-points threshold in his book for a 30-dollar stock he is referring a 20-percent pullback. Think in terms of $3 = 1 margin, $6 two-margins and $12=4-margins when computing the threshold.
The book Livermore wrote explains the market turns as a formation of a pattern double top or double bottom. This is not part of the code and there was no logic to account for this rule. It is obvious that one can’t discount a market turn in a V shape (as it happens) but one must make provisions for a failsafe rule.
(Much like the turtle system false break out rule)
On page 44 Livermore discusses the “pivotal point”.
“For example: Take a stock, which has been in a Downward Trend for sometime and reaches a low point at 40. Then it has a quick rally in a few days to 45, then it backs and fills for a week in a range of a few points, and then it starts to extend its rally until it reaches 49 ½.
The market becomes dull and inactive for a few days. Then one day it becomes active again and foes down 3-4 points, and keeps going down until it reaches near the pivotal point near 40.”
I am still pondering this and the puzzle it presents to code the system into a concrete set of rules. Ideally the fail-safe rule will be an option and one can test multitudes of scenarios with and with out it. This I leave for the application development but continue with testing in Wealth-lab.
The Key price using the aggregate price of the leader and the follower is not used in my model simply because to software limitations.
Livermore used to follow 2-3 prices when followed a sector. If he traded steel stocks he would follow US Steel and Bethlehem Steel. One was always the leader if the group and the other were the laggard. He would also add the prices together and use them as the key price. The threshold used for the key price was double of the threshold used for individual stocks. The reason for this was to get a confirmation of the move from the laggard. If the laggard showed a pivotal point he could be more assured that the signal in the leader will make him money.
Livermore tried to get an edge on his competitors anyway he could get.
Using the Key Price is not yet part of my code in either back-testing platform mainly due to programming difficulties and trying to keep the scripts clean and understandable
Translation to Wealth-lab developer
TradeStation 2000i while may be a very widely used platform is not my favorite. I do not like the programming language or the interface. I am transforming the code into Wealth-lab developer or try using it manually with Track N Trade Pro 4.0 – my favorite charting package. Ideally if you are a programmer you should just bite the bullet and code up a testing or trading harness in C++ or some other flexible and useful PC programming language.
We have access to offshore teams and have done at least a hundred small projects ranging from $100 to $1500.
This code and book is not a turnkey system to get rich with. This is an educational and research project to better us as traders and honor Livermore as well.
There are programmatic limitations in all packaged software like TS 2000I and Wealth-lab. Copies you may purchase will end up in the mothball for lack of support and enhancement from the company due to nefarious dealings with broker firms.
Coding strategies may result in unpredictable results like in TradeStation referring to a bar back several days or even weeks may prove to be problematic at best. It all seems to work but in reality it does not.
The DIS chart below shows the system's forte in picking out trends.
In this instance the Yellow (Natural Reaction State) is rather short and we get out on the top.
The reader may want to get out during the natural Reaction State when long and this state has a severe draw-dawn.
The second chart shows that the Natural Reaction can be more severe. It is possible to get out and reenter the trade when the up trend resumes. Right now the system is not programmed that way.