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The Livermore System

A previous article provided a glimpse of the tumultuous life and career of Jesse Livermore who is known to many as the greatest trader Wall Street has ever seen. Whether that's precisely true or not you do not get a valediction like that without displaying a long history of stunning achievment. Livermore is said to have participated in every major stock and commodities move from 1910 - 1940.

He had to be doing something right.

Let's set the scene for the Livermore era. There was no television, no computers, no internet, and for most of that period no comprehensive chart services. Even for the big-time operators who could afford to bankroll a staff, the absence of instant information and computational resources meant that a successful trading system had to be based on undoctored data, be easy to understand, and be simple to implement.

Livermore was a trend follower. He only took positions in the direction of the trend, and he added new postions whenever his system told him to do so."We know that prices move up and down. They always have and they always will. My theory is that behind these major movements is an irresistible force. That is all one needs to know...Just recognize that the movement is there and take advantage of it by steering your speculative ship along with the tide."

The basic rule to the Livermore System, therefore, is to take positions only in the direction of the trend. In or out. Long or short. No matter how many grams of silicon you want to throw at a modern, computer-based trading system it all comes down to those two choices. Livermore did not obligate himself to trade every day nor did he try to catch every countertrend jiggle. What did he do?

The Livermore System defines the market (the trading ticker) in terms of trend and swing. An upswing, for example, is a consecutive series of higher pivot highs and higher pivot lows. An uptrend is a consecutive series of upswings. A downswing is a consecutive series of lower pivot lows and lower pivot highs. A downtrend is a consecutive series of downswings.

Trends and swings are determined by two filters. A larger swing filter and a penetration filter that is one-half the size of the swing filter. A change in trend is a reversal of swing filter size from the last up or down swing. A pivot is the high or low point of each swing. Time is not a consideration in the Livermore System or in the construction of a swing chart.

Livermore Swing Chart

A swing chart is created somewhat like a point and figure chart. Instead of Xs and Os and box sizes, with a swing chart a vertical line is drawn when prices have moved the swing filter distance in the opposite direction from the previous high or low pivot.

Livermore used penetrations of the pivot points, marked by "P" on the swing chart, to either add new positions when they occurred in the direction of the trend, or as stop-loss levels when they occurred in a direction opposite to the trend. The Livermore System is somewhat unique because of the role of the penetration filter. Many other swing trading systems use any breakout of a prior pivot high pivot or low pivot as the signal to add positions or as a stop loss level.

All positions were liquidated at the first penetration of a stop-loss level. A second penetration of the next occurring pivot in the direction of the new trend confirmed the new trend. A new trend "failed" when the second confirmation did not occur. In those cases Livermore would reenter in the direction of the prior trend when prices exceeded the size of the swing filter from the failed trend's highest high or lowest low.

(c) Peter Amaral TradingFives