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Seven Trading Lessons from a Legend

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Try following the time-tested rules of Jesse Livermore.

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The late Jesse Livermore is considered one of the best traders of all time. His exploits have been chronicled in several books, with the most widely read being Reminiscences of a Stock Operator by Edwin Lefevre, originally published in 1923.

Livermore was wealthy and broke several times over during his tumultuous life, which ended in his suicide. His ability to make and lose millions garnered him many lessons which the trading community have enshrined over the decades since his death. Yet these lessons and rules remain as pertinent today as they were in the early twentieth century.

We'll take a look at several of his trading rules to remind us why we must have a plan in place before trading a dollar of our hard-earned money.

(I must give credit to the Lefevre book mentioned above, as well as Jesse Livermore: World's Greatest Stock Trader by Richard Smitten, for the following ideas.)

Lesson Number One: Cut your losses quickly.

Nowhere is this rule more apparent than in the modern-day crash our markets experienced in the fall of 2008. For those market participants who "bought, held, and hoped," the gut-wrenching drop left them paralyzed, disillusioned, and angry at the market. They felt like they had no control and no choice as the losses spiraled down the rabbit hole. The primary culprits of this death trap are hopeful thinking and fearful paranoia.

As a market slides lower, a trader will rationalize his losing position by either doubling down (buying more at these now-cheaper prices) or at the very least, holding on because "there's just no way this market can go lower." If merely this one simple rule was implemented to "cut your losses," the vast majority of traders would be light years ahead of the crowd.

As soon as a trade is contemplated, a trader must know at what point in time he'll be proven wrong and exit a position. If a trader doesn't know his exit before he takes the entry, he might as well go to the racetrack or casino where at least the odds can be quantified. Trading without an exit plan is like driving a car without insurance. You might go years without a major crash, but when the crash occurs (and it will), you want to be protected from a major financial disaster.

Lesson Number Two: Confirm your judgment before going all in.

Livermore was famous for throwing out a small position and waiting for his thesis to be confirmed. Once the stock was traveling in the direction he desired, Livermore would pile on rapidly to maximize the returns. He admitted that his biggest mistake was holding on to a position as it ran against him, and then selling out when the pain got too great.

Livermore learned to remedy this dilemma by taking on a small line at first, and only adding when he was proven correct. There are several decent ways to buy more in a winning position (pyramiding up, buying in thirds at predetermined prices, being 100% in no more than 5% above the initial entry) but the take home is to buy in the direction of your winning trade -- and never when it goes against you.

Lesson Number Three: Watch leading stocks for the best action.

One hundred years, ago Mr. Livermore didn't have near as many issues to track, yet he made it his mission to follow the market makers and big players when their money flooded into a specific stock or commodity. Livermore knew that trending issues were where the big money would be made, and to fight this reality was a loser's game.

Today, traders have the ability to track sectors, ETFs, and the footprints of the best mutual-fund managers to ascertain where the heavy hitters are moving their capital. Superstars such as Google (GOOG), Goldman Sachs (GS), and General Electric (GE) can also show their hand when looking at the bigger picture of overall market health. Traders ignore these tells at their own peril.
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