Chapter 9: Jesse Livermore's Trading Rules

The Six-Point System  

Livermore Market Key （ I coded this indicator), also published on TradingView.

In Jesse Livermore's classic book How to Trade in Stocks, he details a systematic method for recording prices known as The Six-Point System (or the Livermore Market Key).

This system was not designed to predict the future but to classify price movements so a trader could distinguish between a true trend and meaningless market noise.

Here is the structured summary of the Six-Point System:

Livermore utilized a 6-point price movement to determine upward and downward trends, a method designed to filter out market noise. When an Upward Trend enters a corrective phase, the previous peak of the trend and the subsequent low of the correction together establish a price range for that period.

Generally, if the market breaks above the previous peak and hits a new high, it signals the end of the correction and the resumption of the Upward Trend. Conversely, if the market breaks below the low of the correction phase and sets a new low—and the magnitude of this new low reaches a specific threshold (e.g., 3 points)——it indicates that the "topping out" process is complete. In this case, the original Upward Trend has ended and transitioned into a Downward Trend. The horizontal red lines in the chart above mark this specific price range of the corrective phase.

When a Downward Trend enters a corrective state, the previous low of the downward trend and the subsequent high of the correction phase together establish the price range for that period.

Generally, if the market breaks below the previous low and sets a new low, it indicates that the correction phase has ended and the Downward Trend has resumed. Conversely, if the market breaks above the high of the correction phase and sets a new high—and the magnitude of this breakout reaches a specific threshold (e.g., 3 points)——it signals that the "bottoming out" process is complete. At this point, the original Downward Trend has ended and transitioned into an Upward Trend. The horizontal black lines in the chart above mark the price range of this corrective phase.

In practice, the market may undergo multiple periods of consolidation. For instance, within a Downward Trend, a correction begins with a Natural Rally, followed by a Natural Reaction. If, during this Natural Reaction phase, a rally occurs with a magnitude of 6 points from the low of the Natural Reaction—but fails to exceed the previous high established during the Natural Rally phase—it is categorized as a Secondary Rally. The same logic applies to a Secondary Reaction. 

Many definitions found online are incorrect. Jesse Livermore categorized market movements into six distinct states:

• Secondary Rally A rally that occurs after a Natural Reaction, where price moves upward but stays within the range established by the previous Natural Rally.

• Natural Rally The initial minor rally, which can occur within either an Upward Trend or a Downward Trend.

• Upward Trend A state where prices exhibit a clear upward momentum, characterizing a bullish market.

• Downward Trend A state where prices exhibit a clear downward momentum, characterizing a bearish market.

• Natural Reaction The initial minor decline, which can occur within either an Upward Trend or a Downward Trend.

• Secondary Reaction A decline that occurs after a Natural Rally, where price moves downward but stays within the range established by the previous Natural Reaction.

Natural Rallies, Natural Reactions, Secondary Rallies, and Secondary Reactions can occur within either an Upward Trend or a Downward Trend. In an Upward Trend, a correction begins with a Natural Reaction; in a Downward Trend, it begins with a Natural Rally. A correction phase is considered to have started when a counter-trend movement of at least 6 points occurs, establishing a defined Correction Range.

From this point, the trend may either resume or reverse:

• Trend Resumption: For an Upward Trend, the trend is considered resumed if the price returns above the upper boundary of the Correction Range. For a Downward Trend, the trend resumes if the price drops back below the lower boundary of the range.

• Trend Reversal: A trend reversal requires an additional 3-point filter for confirmation.

  • Upward to Downward: If the price breaks below the Correction Range and continues to decline by an additional 3 points, the trend shifts from Upward to Downward.

  • Downward to Upward: If the price breaks above the Correction Range and continues to rise by an additional 3 points, the trend shifts from Downward to Upward.

During the consolidation phase of an uptrend, if a rebound first fails to challenge the previous high and then drops by more than 3 points, this could constitute a warning signal that the uptrend is about to reverse.

During the consolidation phase of a downtrend, if a pullback first fails to challenge the previous low and then rebounds by more than 3 points, this could constitute a warning signal that the downtrend is about to reverse.