The Role of Intuition in Trading

In his classic book Reminiscences of a Stock Operator, Edwin Lefevre's protagonist, Larry Livingston, makes his first great killing in the stock market as a result of what he calls "gut feeling," or intuition.

(For the sake of simplicity, I'll call Larry Livingston Jesse Livermore, for that is supposed to be the real-life speculator that Lefevre modeled his character on.)

In April 1906, Livermore was on vacation in Atlantic City. As luck would have it, one morning, while strolling along the boardwalk with his friend, Livermore came upon a brokerage office. Being naturally curious, he went inside to see how the market was doing. Mind you, he had been out of stocks at the time and was just there to enjoy a well-deserved rest.

The market was climbing on heavy volume, and the Dow was up several points (back in those days, several points was a big deal). Livermore shot a glance over to the quotation board when his eye suddenly caught Union Pacific (NYSE: UNP  ) . The stock was rallying, which was no surprise because it was a market bellwether -- the most bullish name in a roaring bull market. UP was deemed impervious.

Suddenly, without hesitation, Livermore picked up a ticket and wrote out an order to sell 1,000 shares of UP short. His friend let out a nervous laugh and said to him, "I think you made a mistake. Shouldn't that have been an order to buy 1,000 shares?" Livermore shot back a puzzled glance.

There was no conscious reason for Jesse Livermore to be selling Union Pacific short. He didn't know anything about the company that anyone else didn't know. Its earnings were strong, its outlook bright. Freight and passenger revenues were on the rise. Its capital position was strong. Yet deep within him, there was the feeling that all was not well.

He picked up another order ticket and wrote out instructions to sell another 2,000 shares short. His friend stared at him with a look of frozen incredulity and simply said, "It's your funeral."

At that point, Livermore felt that he had sold enough and decided to go to lunch. When he was finished, he went back to the brokerage office only to see that the price of UP had climbed higher since his last sale. His friend shook his head and mocked with glee, "You see, I told you so."

Livermore was unconcerned. He was heavily short the most bullish stock in a bull market, but for some reason, he felt strangely calm and at ease.

The next day, Union Pacific backed off a little, and Livermore sold 2,000 more shares short. That night, he cut his vacation short and returned to New York in order to be "Johnny on the Spot" in case something happened.

The next day came news of the great San Francisco earthquake. The entire city had been leveled and was engulfed in a raging conflagration. The tracks of Union Pacific, which were heavily spread around the area, were ripped apart. Livermore had acted on an uncanny premonition, for which there was no obvious explanation. But it was not yet time for him to collect his prize.

Despite the news of the earthquake, the entire stock market remained strong, giving up only a few points at first and then rebounding. Union Pacific stock just would not go down. Livermore was heavily short, and his position looked increasingly futile. Even his associates urged him to cover. That friend of his from Atlantic City admonished, "You see, Jesse, the market never lies." To which Livermore replied, "Yes, the market never lies, but it doesn't always tell the truth on an instant, either."

Livermore knew that the bulls who had been accumulating massive holdings for months weren't going to be easily dislodged. Still, he held on. The hunch that had impelled him to sell in the first place continued to possess him.

Sure enough, as the full scope of the disaster became apparent, the market began to slide. At first, it was a measured, orderly retreat without any indication of panic. Then it utterly gave way into the full-fledged crash that Livermore had been expecting. Incredibly, he held off still, deciding instead to double his ante by unleashing wave after wave of selling. The bulls were on the run. On the following day, he covered, making a killing in the process.

The moral of the story is, as traders, we all fight the internal battle between what our "gut" is telling us and what our analytical skills are telling us. We also battle with what we want to happen based on the positions we're holding. (This last is deadly.) An experienced trader should take a lesson from Livermore and allow intuition to play a part in the decision-making process when trading, but not all of us were born with Livermore's uncanny intuition. It's a very fine line between what our gut tells us, what our brain says, and what our emotions leave us hoping for.

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Fool contributor Mike Norman is the founder and publisher ofThe Economic Contrarian Updateand a host of BizRadio Network. He does not own shares in any of the companies mentioned in this article.


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