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Reminiscences of a Stock Operator by Edwin Lefevre

February 18th, 2009

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Reminiscences of a Stock Operator

by Edwin Lefevre
Originally Published in 1922

Reminiscences of a Stock Operator by Edwin Lefevre

Reminiscences of a Stock Operator by Edwin Lefevre

Key Takeaways

Reminiscences of a Stock Operator is the fictionalized biography of Jesse Livermore, one of the greatest stock market traders / speculators ever.  Lawrence Livingston is the fictionalized character representing the real life Jesse Livermore.  The book is a must-read for the serious investor / trader / speculator. 

My biggest takeaway is that, although the book was written nearly a century ago, Wall Street remains essentially the same, and that even today there is a lot to be learned from Livermore’s trading insights. It is easy to discredit the Reminiscences story because it is nearly a century old, but you must keep in mind that Jesse Livermore was a ‘super trader’ of similar stature as a George Soros, Paul Tudor Jones, Steven Cohen, or John Paulson of today. He towed an enormous line and was feared and respected up and down Wall Street.

The book includes numerous famous quotes.  Please visit my other site to read all of the best Finance Quotations from Reminiscences of a Stock Operator.

The point of the book is to argue that it is impossible for traders to consistently beat the stock market.  Lefevre uses Livermore as his example.  Livermore was extremely smart and capable, the most astute trader of his era, but he went from boom to bust, and died penniless, just like the other common speculators.

Ironically, Jesse Livermore committed suicide in 1940 in a New York hotel cloakroom.  He left a suicide note describing his life as a “failure”.  During bust sequences in the book, Livermore talks of being stressed out, depressed, and despondent.  This is a warning to those considering trading as a career.

The last chapter of the book is particularly interesting because it briefly chronicles the rise and fall of legendary traders from the 1800s.  After spectacular rises, each, inevitably, went bust and died penniless.  Lefevre’s point was that sooner or later, the odds catch up to all successful traders and that the market taketh whatever it had heretofore giveth. The book is full of excellent trading insights, but is ultimately a warning to would-be speculators that beating the market is impossible over the long term.

The timeless insights found within Reminiscences of a Stock Operator have schooled generations of investors and make this book one of the foremost investment classics of all time.

Jesse Livermore won and lost tens of millions of dollars playing the stock and commodities markets during the early 1900s.  At one point he made ten million dollars in one month of trading – an astronomical sum for his time.

His ideas and analysis of market price movements are as true today as they were when he first implemented them. He offers profound insights into the motivations, attitudes, and feelings shared by every investor, Reminiscences of a Stock Operator, is among the most compelling and enduring pieces ever written on trading in the markets.

Page 12 – Merchants in Wall Street

Livermore talks about how successful businessmen will manage costs down to the last penny and take days or weeks to research and investigate the smallest factors affecting their business, but that they throw caution to the wind and plow tens of thousands of their hard earned dollars into a stock without thinking twice after hearing a quick tip from a friend or news periodical.  He says this is a suckers play.

The sucker play is always the same: to make easy money.  That is why speculation never changes.  The appeal is the same: greed, vanity, and laziness.  The merchant who would not dream of buying and selling on the advice of fools goes to Wall Street and cheerfully risks his money on the say-so of men whose interest is not his interest.

Page 21 – Speculators’ Weaknesses

In this section Livermore covers the most common weaknesses that lead to losses by “suckers”:

Motive: the sucker wishes to get something for nothing.  His motive is greed, laziness, or the excitement of gambling.  Livermore’s motive is solely to win, or to be right.

Trading In and Out of Season: the sucker often trades without an edge or without a patient setup.  Livermore waits patiently, sometimes for months or years before making a trade.  He waits for the perfect setup and does not compromise by trading just to trade.  This is a big theme in Livermore’s strategy: that there is no harm in sitting and waiting on the sidelines for months at a time for the perfect set up.

Hope: the average sucker buys a stock and then does little more than hope.  He says that most men lose money because they are governed by fear or hope.  Livermore doesn’t hope or fear – he thinks. He takes a dispassionate view of the markets.  Livermore’s aphorism is to “never argue with the tape.”

Lack of Knowledge of the Game: the suckers don’t understand economics, fundamental analysis, technical analysis, or market action.  Livermore knows all of these things and studies them constantly.  He reads trade reports, hires experts, reads company filings, and is constantly on the job.

Inexperience in the Stock Market: the sucker plays the stock market in his spare time.  The stock market is the one business Livermore knows.  He has been trading stocks since he was fourteen years old.

Tempermental Unfitness: the sucker is easily shaken or flustered, is shortsighted, has a poor memory, and/or lacks ticker sense.  Livermore is not easily shaken, is farsighted, has an excellent memory, and has great market instincts.

Page 51 – When the Clock Struck Three

One of Livermore’s themes is to wait patiently for a set up and then go confidently in a chosen direction.  This is not to say traders should not cut their losses.  They should cut losses immediately.  However, Livermore says that his losses have taught him ‘not to begin an advance until he is sure he will not have to retreat’.  If he is not supremely confident in a direction, he does not advise to move at all.  Again, his advice is not to trade without an edge.  In his words, ‘don’t trade out of season’.

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The Alchemy of Finance by George Soros

January 14th, 2009
The Alchemy of Finance George Soros

The Alchemy of Finance George Soros

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The Alchemy of Finance

by George Soros
Originally Published in 1987

Key Takeaways

This is not an easy book to read, but it deserves your attention.  I had heard the book should be skipped because it is long winded and difficult to follow.  But Soros is such an important figure in the world of investments that I had to read his seminal book on his Theory of Reflexivity and trading activity.

Although George Soros has a brilliant mind, he’s not necessarily a brilliant writer.  He used four hundred pages for ideas that should have been expressed in two hundred pages.  I don’t regret reading the book though.  He is a philosophical man with a lot of thought provoking ideas.  I respect his Theory of Reflexivity and enjoyed learning how Soros used it to identify investment opportunities while running his Quantum Fund in the 1980s.

The book has three core parts (officially it has five parts, but I take the liberty of viewing them as three): Part One advances Soros’s Theory of Reflexivity, Part Two is a journal account of Soros’s trading activity, and Part Three includes a potpourri of philosophical meanderings on the markets.

Part One is useful for its explanation of the Theory of Reflexivity, but it should have been condensed to 1/3 the number of pages.  Part Two is excellent for its rare view into the trading mind of the most successful hedge fund manager of all time.  Part Three was largely useless – it is composed of philosophical meanderings that he will later dismiss as irrelevant or incorrect.  What was the point?

Readers looking for concrete investing strategies, similar to those provided in James Altucher’s How to Trade Like a Hedge Fund, will be disappointed. The book gives you strategies, but they come on Soros’s terms – in an abstract form.  Largely philosophical and esoteric.

I have encountered several incorrect accounts of George Soros’s Theory of Reflexivity.  Most people oversimplify the interpretation and miss a final important concept.  Read on for a clarification of the reflexivity concept and what I believe are the key takeaways of the book.  If you like what you see, I encourage you to purchase the book here.

Page – 3 New Introduction to Reflexivity

The Concept of Reflexivity: In situations that have thinking participants, there is a two way interaction between the participants’ thinking and the situation in which they participate.  The two functions can interfere with each other by rendering what is supposed to be given, contingent.

Soros calls the interference between the two functions “reflexivity”.  He views reflexivity as a feedback loop between the participant’s understanding of a situation, and the actual situation in which the they participate. Thus, situations with thinking participants are circular.

Soros claims the concept of reflexivity is especially useful when evaluating financial markets, and that the concept of reflexivity succeeds where traditional economic concepts fail.   His writing becomes philosophical and technical, but he essentially tries to refute the belief that financial markets arrive at ‘rational’ and ‘efficient’ equilibria.  He says, “The Alchemy of Finance was meant to be a frontal assault on the prevailing paradigm.”  In the end, he holds that the Theory of Reflexivity is a superior theory to the efficient market hypothesis.

Soros starts off by saying that market participants (e.g. investors’) perceptions can influence prices.  And that this is especially obvious during times of greed or fear.  Prices get bid up or sold off irrationally because of people’s perceptions.

On the surface this sounds exceedingly obvious, and is why many people dismiss Soros’s Theory of Reflexivity as worthless.  For example:

“Reflexivity is nothing more than the notion that market participants affect a price, but that prices are dynamic and constantly influenced by perception — and here’s the GREAT insight — and perception sometimes is misled by unfounded herd momentum.”

or

“His philosophical tenet, Reflexivity, denotes a feedback loop: Individuals act on their views of a situation, thereby changing the situation. For example, if traders believe a stock is going up, they buy it, thereby bidding it up. But their belief caused the result; there may be no fundamental reason for the rise. Thus what we think determines what we do and has consequences, but typically it is not correct.”

Each of these readers miss the crucial and final point in the Theory of Reflexivity’s application in the financial markets.  They miss the point that while prices may rise initially on perceptions only, that prices can affect perceptions such that perceptions begin affecting fundamentals.

This is Soros’s crucial point.  That prices affect perceptions and that perceptions affect prices and that prices in turn affect fundamentals. So perceptions affect fundamentals.  i.e. perceptions can (temporarily) make an industry ‘fundamentally’ stronger.

In Soros’s own words:

Many reviews described reflexivity by saying that prevailing sentiments greatly influence market prices.  If that were all, I would be indeed belaboring the obvious. What makes reflexivity interesting is that the prevailing bias has ways, via the market prices, to affect the so-called fundamentals that market prices are supposed to reflect.  Only when the fundamentals are affected does reflexivity become significant enough to influence the course of events.  It does not happen all the time, but when it does, it gives rise to boom/bust sequences and other far-from-equilibrium conditions that are so typical of financial markets.

If this is still confusing, let me provide an example:

Reflexivity explains why the technology boom of the late 1990s got so out of control.  From 1997 to 2002 the Nasdaq rose from 1,200 in 1997 to 5,000 in 2000 and then fell back to 1,200 by 2002. That’s a tremendous change in value in a short period of time, and cannot be explained by an ‘efficient’ and ‘rational’ market.

How did this happen?

The Soros Theory of Reflexivity says that perceptions influenced prices and that prices influenced fundamentals. But that supporting fundamentals with perceptions is eventually unsustainable and that the entire structure eventually collapsed.

Let us consider the Theory of Reflexivity in the context of the consumer Internet sector in the late 1990s.  Yahoo! pioneered the sector and started out as a healthy and profitable company offering Internet services to users and advertising space to advertisers.  As Yahoo! continued to grow, it attracted more and more users, which in turn enabled it to sell more and more advertising space to advertisers.  This increased Yahoo!’s profitability, which in turn caused investors bid up Yahoo! shares to reflect the company’s increased value.

Now Reflexivity starts to enter the picture.  Yahoo!’s success attracted a first wave of Internet startup imitators.  The first wave of Internet startup imitators were able to point to the growth and success of Yahoo! shares to raise venture capital. After raising venture capital, the first wave of Internet startup imitators purchased advertising space from Yahoo to attract new users to their web sites.  This enhanced Yahoo!’s profitability.  It also provided the first wave of Internet startup imitators the opportunity to begin selling advertisements on their own web sites.  This caused investors to bid up the shares of Yahoo! and of the first wave of Internet startup imitators.

Increasing share prices attracted more investors and a second wave of Internet startup imitators. The second wave of Internet startup imitators purchased advertising space from Yahoo! and from the first wave of Internet startup imitators.  This increased the profitability of Yahoo! and it increased the profitability of the first wave of Internet startup imitators.  Soon, Internet startup imitators were raising more and more venture capital and were purchasing more and more advertising space from each other.  You can imagine how the system perpetuated itself.  More and more advertising revenue, meant more and more investment, meant more and more web services for users, meant more and more eyeballs, meant more and more advertising dollars, meant more and more investment.  The system was self reinforcing.  And the fundamentals looked great.  Lots of revenue and profit growth – all correlated to ‘eyeballs’.  The numbers did not lie either – revenues, and in certain cases, profits, were growing smartly.  All fueled by investor perceptions that had ‘altered’ the fundamentals.

Some observers will counter, “The web services the Internet startups were providing had value.  Once they gained ‘critical mass’, the Internet startup imitators stopped purchasing advertising and could ‘self fund’ through organic web usage.  Sure, lots of investors lost money on bad companies, but that was just a consequence of speculation, i.e. funding the bad companies, instead of the good.”

Yes, some companies could stand on their own. Yahoo! was profitable and could ‘self fund’.  About.com was profitable and could ‘self fund’.  Match.com was profitable and could ‘self fund’.  And yes, thousands of other companies were doomed regardless – they would never have provided enough ‘organic’ value to stand on their own, and were probably only the result of pure speculative excess.  But there was an undeniable slice of firms in the middle that temporarily thrived on the ‘reflexive cycle’, and who only existed in the first place because of funding fueled by investor perceptions.

Reflexive systems have a way of reinforcing themselves until savvy investors start to catch on that the system is unsustainable in the long run, and pull their money or until an outside event occurs that causes a pullback.  Once savvy investors caught on to the fragile business model of Internet companies, and their reliance on venture capital derived advertising revenue, they began to pull money and the entire system was flushed of the firms that relied unduly on the ‘reflexive cycle’ for Internet advertising.  In the end, reflexive cycles end violently because perceptions can change quickly.  And when perceptions change at the end of a reflexive cycle, changes in fundamentals quickly follow.

The Alchemy of Finance covers numerous examples of reflexive boom bust systems, such as the sovereign lending boom of the 1970s where it was not recognized that credit extension enhanced the various debt ratios by which the banks measured a borrower’s creditworthiness, or the conglomerate boom where investors put a high value on earnings growth through acquisitions that reinforced the overvaluation of conglomerates, or the technology boom where investors valued top line revenue growth which could only be sustained by selling more stock at inflated prices.

I hope I have accurately described Soros’s concept of a reflexive process.

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The Post American World by Fareed Zakaria

January 10th, 2009
The Post American World by Fareed Zakaria

The Post American World by Fareed Zakaria

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The Post American World

by Fareed Zakaria
Published in 2008

Key Takeaways

Don’t let the title fool you.  The first sentence of the book reads, “This is a book not about the decline of America but rather about the rise of everyone else.  It is about the great transformation taking place around the world, a transformation that, though often discussed, remains poorly understood.”  This is not a book about America’s decline, but a book about the emergence of the rest of the world and how America can best fit into the new world order.

I am a fan of Dennis Gartman’s The Gartman Letter.  The Gartman Letter is a widely read daily commentary on the global capital markets.  It is subscribed to by traders and investors globally. A few weeks ago Dennis extended, for only the fourth time in his letter’s 20+ years in existence, a new ‘must read’ book recommendation to his readers.  This recommendation was The Post American World by Fareed Zakaria.  His past recommendations have been: Reminiscences Of A Stock Operator by Jesse Livermore, both Market Wizards books by Jack Schwager, and By The Numbers by W. Stansbury Carnes and Stephen Slifer – all investing classics. So when he recommended The Post American World, I went right out and bought it.

Putting the book into the same vaunted category as Reminiscences Of A Stock Operator and Market Wizards is a stretch, but I liked the book and thought it was worthwhile.  My overall take is that the first five (of seven) chapters were mediocre, but that the last two chapters were excellent.

The problem with the first five chapters is that they are yet another rehash of the Brazil, Russia, India, China (BRIC) story.  Zakaria throws out all the predictable statistics and their implications: population size, economic growth, engineering talent, economic progress, opening of markets, widgets manufactured, outsourcing trends,  cultural dispositions, etc.  As someone who has heard the BRIC story ad nauseum since 2003, the chapters were largely recycled.  If you’re not familiar with the BRIC story, or want another rehash, then the first five chapters are very good.

The last two chapters of the book are where Zakaria’s book shines.  In the following post, I have summarized what I believe are the Key Takeaways of the book.  If you like what you see, I encourage you to buy the book.

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Trend Following: How Great Traders Make Millions in Up or Down Markets by Michael Covel

January 6th, 2009
Trend Following Michael Covel

Trend Following Michael Covel

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Trend Following: How Great Traders Make Millions in Up or Down Markets
by Michael W. Covel
Published in 2005

Key Takeaways

I’ve read a lot of investing books.  And this may well be the worst.  All fluff and no substance.  Reminded me of a bad high school English paper that spams the reader with superfluous words and narrow margins to meet a page count requirement.  After 150 pages, I seriously considered abandoning the book and moving on. But its in my DNA to finish any book I start, so I tortured myself skimming the last 250 pages of uselessness.

Trend Following is an excellent trading strategy and deserves to be studied.  But Covel, in Trend Following, is not the way to learn.  Covel goes in circles gushing about how great Trend Following is and about how great the Hedge Fund managers are that employ Trend Following.  But he sounds much more like a starstruck high school girl with a teenage crush than a trading guru.  He never gets around to giving us the beef.

Definitely don’t buy this book, you can get what you’re looking for in this post where I profile the techniques he covers, or you can read my post on ‘The Slow Turtle Trade‘ from James Altucher‘s book How to Trade Like a Hedge Fund.  When I find a good Trend Following book, I will update this post.

The one thing Covel did well was collect some excellent quotes on Finance, Trading and Investing.  He included at least two quotes per page (presumably to make up for lack of original material and to boost his page count).  For this, I was grateful and have provided the best in my post on Finance Quotations.

Page 266 – Trend Following Systems

(Yes, it took Michael Covel until 266 pages into his 400 page book to write anything worth remembering.)

Fast Simple Moving Average (SMA) Crossover of the Slow Simple Moving Average

  • Buy the index when the Fast SMA (50 day) crosses over the slow SMA (100 day)
  • Sell and then go short when the fast SMA (50 day) crosses under the slow SMA (100 day)
  • Set a stop loss of four times the Average True Range (ATR) of 10 days

Note: The stop loss risk control avoids a loss of more than 2% of equity

Note: The True Range is the absolute value of the greatest of the following:

  • The distance from today’s high to today’s close
  • The distance from yesterday’s close to today’s high
  • The distance from yesterday’s close to today’s low

The Average True Range calculates the Simple Moving Average to the True Range.

Results:
Backtesting this trade from November 2001 to March 2002 results in a an average annualized return of 19.6% with a maximum drawdown of 46%.  But less than 40% of the system’s trades are profitable.  Using sensitivity analysis for the number of days to use in the Fast and Slow SMA, combinations in the 40 – 60 fast SMA days and 100 – 120 slow SMA days provide the best results.

Fast Simple Moving Average (SMA) Crossover of the Slow Simple Moving Average with Pattern Entry

This system combines trend following and countertrend concepts.  It is called Trend with Pattern Entry (TPE) and was first introduced by Dion Kurczek and Volker Knapp in Active Trader Magazine in April 2003.  The premise is that prices above the SMA indicate a bull trend, but should only be bought on countertrend pullbacks.  Similarly, prices below the SMA indicate a bear trend, but should only be sold short into countertrend rallies. The prices wait for three consecutive countertrend (down or up) days before entering the market.

  • Buy the index if the price is above the 100 day SMA and the closing price decreased over the last three days.
  • Exit the position (sell) if the price reaches the trailing stop, which is 4 times the ATR of 10 days subtracted from the current closing price.
  • Then short the index if the price is below the 100 day SMA and the closing price increased during the last three days.
  • Exit the position (buy to cover) if the price reaches the trailing stop, which is 4 times the ATR of 10 days added to the current closing price.

Results:
Backtesting this trade from October 2000 when the market experiences a strong up-move three times in a row while still below the SMA.  The system starts short and finally ends in early 2002.  The system generates 21.8% annualized returns, but experiences several drawdowns of over 20% and one of 49%. Indeed, large drawdowns are the biggest challenge for Trend Following systems.  The large drawdowns are why investors are instructed to Trend Follow a basket of uncorrelated assets and commodities.  If an investor were to get hit by highly correlated large drawdown across all investment classes, it could wipe them out.

There are several variations to these techniques such as Pyramiding, or adding to a position shortly after the trend is validated and proved profitable.

Remember, the best part of the book are the quotes Covel collected, so be sure to visit my post on Financial Quotations.

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