Transcription
The difference between a healthy market reaction and the beginning of a genuine reversal is the most expensive lesson you will ever learn on Wall Street. Most men pay for this knowledge with their entire fortune, sometimes more than once.
They are shaken out of the trade of a lifetime by a meaningless twopoint drop, selling their position just as the stock is taking a breath before its next 100point advance. Or in the opposite and far more ruinous scenario, they hold a position through a 10-point decline, calling it a normal pullback, only to watch it become a 50point catastrophe that erases their account. They confuse a minor ailment with a terminal illness, and in this business, a failure in diagnosis is a prelude to financial ruin. The market does not forgive such errors in judgment. It presents you with the bill, and the bill is always for the full and catastrophic amount.
I learned this not from a book, but from the relentless drilling of the ticker tape, which in your era is the ceaseless flicker of the electronic chart on your screen. The principles are identical. In my early days, I was brilliant at catching the start of a move. I could sense when the pressure was building, when a stock was ready to run. I bought Anaconda Copper when it was trading below 300. My analysis was flawless. The stock was being accumulated by the strongest interests in the country. And the general market was poised for a great rise. It began to move as I anticipated. It ran up 10 points, then 15. Then it pulled back four or five points. I, being young and eager to book a profit, and fearful of seeing that profit evaporate, sold my line. I congratulated myself on my cleverness, and then I was forced to watch with the agony that only a speculator can know, as Anaconda proceeded to climb to 400, then 500, and far beyond. My profit was a pittance. My potential profit was a fortune. I was right about the direction, right about the stock, right about the market, but I was wrong in my courage and my patience. I had sold a perfectly healthy bull on its first pause to catch its breath.
This happened not once, but dozens of times. My trading ledger was a testament to my skill in analysis and a tragic monument to my failure in sitting tight. The great money, the lifealtering money is not made in the buying or the selling. It is not made in the quick scalp or the nimble day trade. It is made in the sitting. It's made by assessing conditions, taking a position, and then staying with it until you have a clear evidence-based reason to believe the trend has run its final course.
But how does one know? How do you distinguish the pause from the end? You require a yard stick. You need a simple unemotional ruler to measure the health of a stock's advance. Without it, you are merely guessing, and you will be whipsawed by your own hopes and fears until your capital is gone.
The market is a creature of mathematics and human emotion. Its movements are not random. They follow patterns of behavior. A stock in a powerful uptrend does not move in a straight uninterrupted line. It advances, then it reacts. It pushes forward, then it pulls back to consolidate its gains, shake out the weak holders, and gather strength for the next assault on higher prices. This is the natural rhythm of the market. The amateur fears this rhythm. He buys at the peak of excitement and sells in the trough of fear during the pullback. The professional understands this rhythm. He knows the reaction is not only normal but necessary. His task is to measure the depth and character of that reaction.
This brings us to the most practical tool I ever developed for maintaining my position in a great move. The rule of the normal reaction. It is a simple measure. When a stock makes a significant advance from a clear pivot point or breakout level, a pullback that retraces approximately 50% of that advance is to be considered a normal and healthy reaction. It is not a sign of danger. It is in fact often a sign of immense underlying strength. Consider a stock that breaks out of a long period of quiet trading at $50 and advances to a temporary peak of $80. The total advance is 30 points. A normal reaction would be a decline of roughly half that amount or 15 points. This would bring the price back to the area of $65. If the stock declines to that level on diminishing volume, holds and then begins to turn up again, it is acting precisely as a strong stock should. The buyers who missed the initial move are stepping in and the original holders are refusing to sell. The trend is not only intact, it has been confirmed. To sell your position because of such a reaction is to commit a cardinal sin of speculation. You are surrendering a winning position for no logical reason other than your own fear. You are allowing the market to bully you out of a fortune.
My greatest successes came only after I learned to sit patiently through these exact kinds of pullbacks. I would hold a massive line of wheat or cotton, and after a 20 point advance, I would watch it give back eight or 10 points. The newspapers would scream that the top was in. The brokers who live on commissions and thus on activity would advise me to take my profits. But I would consult my own records and my own rules. The reaction was normal. It was within the expected bounds. The stock was acting right. And so I did nothing. I sat and in the sitting I made millions. The subsequent advance that followed such a normal reaction was often more powerful and swift than the initial one.
Jesse Livermore consistently stressed that Wall Street extracts a heavy cost of instruction for every lesson learned the hard way. Fortunately, the core principles he developed to survive these expensive market penalties were captured for posterity by Edwin Lev in the 1923 masterpiece reminiscences of a stock operator. It stands as the finest possible literary training ground, allowing you to absorb decades of painful operational experience without ever having to risk a dollar of your own capital. To ensure this timeless wisdom translates accurately to the modern computerized arena, we advise seeking out the MaxDavidson annotated edition. Davidson's careful commentary is indispensable for bridging the gap between Livermore's era and ours. A link to this essential edition is provided in the description below.
Now you must understand the other side of this ruler. If it is a tool for patience, it is also a fire alarm of the most urgent kind. If a stock retraces more than 50% of its advance, its character has changed. The danger signal is flashing. Let us return to our example of the stock that moved from $50 to $80. We established that a pullback to $65 is normal. But what if it does not hold at 65? What if it slices through that level and then through 60 ts and then $60, particularly on an increase in volume? This is no longer a normal reaction. This is a reversal. The underlying buying power that drove the stock up has been exhausted and now the sellers are in complete control. The line of least resistance which was once pointing straight up has now decisively turned down. At this point, your duty is not to hope. It is not to consult your original thesis on why the company is a good investment. It is not to wait for it to come back. Your duty is to sell your entire position immediately. To hesitate is to court disaster. The moment a stock violates the bounds of a normal reaction. It is telling you that you are wrong. Not that you might be wrong, but that you are wrong. The tape does not lie. Men who argue with the tape are destined for the poor house. A loss of more than 50% of an advance is a fundamental change in the stock's behavior. The bull is no longer resting. It has been gravely wounded, and you do not want to be riding a wounded bull.
The application of this rule in your modern markets is straightforward. First, you must clearly define the move you are measuring. Do not measure from the absolute bottom of a crash to the top of a speculative frenzy. Measure the most recent, clearly defined swing. This is typically from the last consolidation or pivot point, the price at which the stock began its clear accelerated advance to the highest point it has reached in the current move. Second, perform the simple arithmetic. Calculate the total points of the advance. Divide by two. Subtract this number from the peak price. This gives you your critical 50% level. Third, and most importantly, observe the behavior of the stock at and around this level. The rule is not a magic line on a chart. It is a behavioral guide. Does the stock meet the level and bounce with vigor? This is bullish. Does it languish there trading heavily without making progress? This is a warning. Does it cut through the level as if it were not there? This is an order to exit.
You must also consider the context of the general market. A stock holding its 50% level during a broad market advance is good. A stock holding its 50% level while the rest of the market is collapsing is a sign of exceptional strength. It is a leader and it is the stock you should be most interested in. Conversely, a stock that cannot even hold its 50% level while the general market is strong is a lagard of the worst kind, and it must be sold without a second thought.
The true power of this rule is psychological. It is a weapon against your two greatest enemies, hope and fear. When a winner starts to pull back, fear grips you. The fear of losing your paper profit screams at you to sell, to take the small gain. This rule silences that fear with cold logic. It allows you to ask a simple question. Is this reaction normal? If the price is above the 50% mark, the answer is yes. And your job is to remain calm and sit tight. It provides the courage to hold through the wiggles that shake out the amateur masses. Conversely, when a trade goes against you and then stages a small rally, hope takes over. You tell yourself, "It's coming back. I just need to hold on a little longer." But if that stock had previously broken its 50% support level, this rule destroys that false hope. It tells you the primary trend is now down, and any rally is merely a selling opportunity, not a sign of recovery. It forces you to be ruthless with your losers, which is the cornerstone of capital preservation. It transforms you from a passive victim of market swings into an active observer who makes decisions based on evidence, not emotion.
I think of my old friend, the speculator known as Old Turkey. When stocks were high and climbing, men would ask him for his opinion. He would shake his head and say, "Well, you know, it's a bull market." They would press him for a reason to sell. He would simply repeat, "It's a bull market." He had the wisdom to stay with the primary trend. He did not get shaken out by the minor reactions because his focus was on the great underlying current. The 50% rule is the analytical backbone for Old Turkey's wisdom. It is the mathematical proof that for your particular stock, it is indeed still a bull market. It allows you to be patient, to be stubborn with your winners, but with a clearly defined point at which that patience becomes foolishness.
Let this be your unbreakable law. Measure every reaction. A pullback that consumes up to half of the prior advance is the market drawing a healthy breath before the next climb. It is a test of your conviction, and you must pass that test by sitting still. But a reaction that exceeds that 50% boundary is the market showing the first signs of suffocation. It is a warning that the oxygen of buying power is running out. Your conviction is now your enemy, and your only logical move is to exit the theater before the fire spreads. You must know the difference between a breath and a death rattle. If you do not, I assure you, it will be your capital that suffocates.