The Most Important Rule for Buying and Selling

What is the most important trick for buying and selling stocks? If you can only learn one, then let it be this: only buy a stock when the evidence of strength presents itself, and sell only upon the symptoms of weakness, and in other times, just stay quiet. 

The Wheat Campaign.

The following story of Jesse Livermore, one of the greatest traders ever, illustrates the point. One day, when Livermore was having lunch with his friends, one of them asked Livermore about a recent trade he made in the wheat market, so Livermore entertained them with his story and said:

“I just felt the demand for wheat in America was underestimated and the price was going to rise. I waited for what I call my pivotal point and stepped in and bought five million bushels of wheat, about seven million dollars worth.

“I watched the market closely after the purchase. It lagged. It was a dull market, but it never declined below where I bought it. Then one morning the market started upward, and after a few days the rise consolidated, forming another of my pivotal points. It lay around in there for a little while, and then one day it popped out on the upside with heavy volume.”

Livermore took it as a good signal and put in an order for another five million bushels. The price kept getting higher and higher and Livermore was very happy, because it was evident that the market was very bullish at that time. The trend roared strong and the price rose steadily for several months in Livermore’s favor. He finally booked a profit of $2,500,000 when the price was 25 cents above his average.

It looked like that it was a successful trade, but instead Livermore commented on his decision, “This was a bad mistake.” His friends were puzzled.

“How the hell could it be a bad mistake to make a profit of two and a half million dollars?” asked one of his friends.

Livermore explained that his mistake was that the wheat futures market had shown no signs of weakness when he sold it. “Simple. Why was I afraid of losing the track’s money? When I sold, I was simply acting out of fear. I was in too big a hurry to convert a paper profit into a cash profit. I had no other reason for selling out that wheat, except that I was afraid to lose the profit I had made,” said Livermore, who realized he had made a great mistake of not having the courage to play the deal out to the end until he got a real definitive sell signal.

“So?”

“I reentered the market and went back at an average price 25 cents higher than where I had sold out my original position. It rose another 30 cents, and then it gave a danger signal, a real strong danger signal. I sold out near the high of $2.06 a bushel. About a week later, it sold at $1.77 a bushel.”

Livermore finished the story with the conclusion that the reason he sold the first time was simply a lack of courage, whereas the second time was different. “The next time I sold the wheat it was different; I could see definite symptoms of weakness. It gave the clues, the hints, the telltale signs of topping out. The tape always gives plenty of warning time for the savvy speculator to heed,” said Livermore.

Think Right and Sit Tight.

You must have to courage to play along until the signs of weakness appear. This is the most important lesson that a trader can learn which, many years later, was emphasized by the great trader again in his biography with this famous quote:

“After spending many years in Wall Street and after making and losing millions of dollars I want to tell you this: It never was my thinking that made the big money for me. It always was my sitting. Got that? My sitting tight! It is no trick at all to be right on the market. You always find lots of early bulls in bull markets and early bears in bear markets. I’ve known many men who were right at exactly the right time, and began buying and selling stocks when prices were at the very level which should show the greatest profit. And their experience invariably matched mine – that is, they made no real money out of it. Men who can both be right and sit tight are uncommon. I found it one of the hardest things to learn. But it is only after a stock operator has firmly grasped this that he can make big money. It is literally true that millions come easier to a trader after he knows how to trade than hundreds did in the days of his ignorance.”

It is a very important piece of the puzzle, but even seemingly easy at first glance, anyone who has ever tried to put it into practice would find it extremely difficult. Just as the first time Livermore sold in the above story, the discipline of a trader is usually overtaken by his fear of losing when his trade is in profit. It demonstrates a strange human behavior that a trader is very impatient with a profitable trade but almost always falls in love with a losing trade. As a result, a trader usually just loses control, acts on his impulsive feeling and forgets this important rule altogether. 

Stick to Your Method.

How can a trader tackle this problem? Former US trading champion and market analyst Robert Prechter believed that the only solution is to have the discipline to stick to your method. “To win the game, make sure that you understand why you’re in it. The big moves in markets only come once or twice a year. Those are the ones which will pay you for all the work, fear, sweat and aggravation of the previous eleven months or even eleven years. Don’t miss them for reasons other than those required by your objectively defined method,” he said.

In all, develop your own method for recognizing strengths and weaknesses in a market, and acquire the discipline to stick to the marvelous rule of buying only on strengths and selling only on weaknesses, or else just sit tight and do nothing. If you are able to do this, you will not be very far away from the promised land of speculative wealth.