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8 Reasons to Trade Exchange Traded Funds Over Stocks

Stock market, Bull vs Bear Markets

Exchange Traded Funds have alot to offer over individual stocks (Flickr.com).

The stock market and volatility go hand-in-hand in today’s 21st century stock market but Exchange Traded Funds, ETF’s, have helped smooth over some of the market’s peaks and valleys. If you’re goal is steady gains then you’d be hard-pressed to find a better instrument to help you along that path. If you’ve never considered ETF’s as part of your overall strategy, then you may reconsider after reading about some of the unique advantages that they offer to help your trading achieve smoother performance without the sleepless nights.

 Access to Alternative Markets

ETF’s give you access to markets that would otherwise be out of your reach. Gold, currencies, copper, timberland, energy, and other investment classes are available to you through ETF’s instead of you having to trade the Forex, store physical assets, or pay margin costs in the Futures market. Plus, you can hedge portfolio using ETF’s but without the costs of rolling over futures contracts or paying the wide bid/ask spread in the Forex.

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A Primer on the Stock Market

A Primer on the Stock Market

 

stock market

stock market—Dannels (Flickr.com)

The Romans invented corporations during the days when Rome ruled the world not only militarily, but commercially. They recognized the need for a legal entity in which individuals could invest while limiting their risk to the amount of their investment. During the Middle Ages, that time that succeeded the end of the Roman Empire, commercial activity was minimal. European economies regresed to an agrarian state in which subsistence was the primary goal and for the most part, only land had value. But as Europe began to emerge and undergo the Renaissance, commercial activity increased. Not long thereafter, much of Europe — not to mention the emerging colonies in North America — entered into the era known as the Industrial Revolution.

With the industrial revolution came a significant expansion of the scope of commercial, business and industrial activity. Manufacturing brought about an enormous increase in the capital required to start a new business, or to expand an existing one. This demand for capital revived interest in the corporation as a form of business organization. Corporations can accommodate many investors, each buying larger or smaller interests, which made the corporation an excellent vehicle to meet the economic needs of businesses as the industrial revolution progressed.

But the resurgence of interest in corporations meant that a system had to be created to facilitate the sales of shares of corporate stock. The system that developed was what we now call “stock exchanges.” The fundamental purpose of a stock exchange is to facilitate the sale of shares of stock, bonds and other securities at consistent prices, and to broaden the availability of and access to such securities.

One of the world’s first big corporations, the Dutch East India Company, was chartered by the Dutch parliament in 1602 to facilitate far eastern trade. In the same year, that company founded the first stock market to facilitate trade in its own shares. The Amsterdam Stock Exchange was the first to trade paper stocks and bonds. It survives today, although merged with the Belgian and French stock exchanges. Later in the Seventeenth Century, William of Orange, a Dutchman, became ruler of England jointly with his wife, who was Mary II of England. During their joint reign, William sought to reform how England financed wars and, in 1693, issued the first government bonds. From this point forward, those bonds, along with common stock of stock companies, were traded in coffee houses along Exchange Alley in London. By 1698, John Castaing, trading out of a coffee house known as Jonathan’s, began to post lists of prices for stocks and commodities. Those lists were the beginning, in rudimentary form, of the London Stock Exchange.

The first American stock exchange was formed in Philadelphia in 1790. But the New York Stock Exchange began in 1792, and quickly became the premier trading forum for stock in America’s largest companies. The standard rapidly emerged that having your company’s stock listed on the New York Stock Exchange was a hallmark of corporate success; to a significant extent, that standard persists today. But there are also other markets in the United States today. The Chicago Board of Trade, established in 1848, was the world’s first exchange for the trading of futures and options, that is, contracts to either buy or sell commodities or stocks in the future at a fixed price. And Amex, the former American Stock Exchange, serves largely as a forum for trading stocks of smaller companies that may not be up to New York Stock Exchange listing standards. In the last twenty or thirty years, AMEX has come to be known particularly as a forum for trading stocks of high technology companies.

Although stock markets post current current prices for stocks, bonds and commodities, as the securities market grew it became important to have some meaningful way to communicate to the public at large what the market as a whole was doing. In 1896, Charles Dow, an editor of the Wall Street Journal, and a business associate, Edward Jones, a statistician, founded Dow Jones & Co. They began to publish an average based on the performance of 30 selected industrial stocks. Soon, the Dow Jones Industrial Average became the benchmark of market performance. It continues today, although the 30 stocks on which it is based change from time to time, and aren’t all industrial any more. The average is also weighted and adjusted statistically to account for stock splits and other phenomena. While other measures and averages also evolved, the Dow is still regarded as the best quick summary of day to day market performance.

 

How the General Economy Impacts the Stock Market

 

Stock markets work, for the most part, on free market economic principles. So as long as there have been stock markets, there have been cycles that included sharp increases in stock prices (a “bull” market) and prolonged decreases in stock prices (a “bear” market). A sudden, sharp, broad-based decline in stock prices is often referred to as a crash. The New York Stock Exchange’s most notable crash occurred in 1929. But there were earlier American crashes, and more recent ones, and there have been major stock market collapses overseas as well. Ordinarily, but not always, crashes and bear markets are the result of factors that happen outside the stock exchanges.

The Amsterdam market, the world’s first real stock market, experienced a crash in 1623 that is generally attributed to the start of the Thirty Years War, and another in 1637 known as the “Tulip Mania Bubble,” brought about by the collapse of overly-inflated prices for tulip bulbs. A stock market crash in France in 1720 resulted from efforts of the Banque Royale to replace gold and silver with paper money.

stock market

stock market—401 K 2013 (Flickr.com)

Bear markets and crashes are hardly strangers to the American market, either. An early example is the “Black Friday” crash of 1869. The crash resulted primarily from the attempts of two speculators, Jay Gould and James Fisk, to corner the market for gold. They hoped to prosper when, as anticipated, gold was used to buy back banknotes that had been used for reconstruction projects after the Civil War. After acquiring large amounts of the metal, Gould and Fisk began to horde it in an attempt to raise its price. When he learned of this, President Grant released for sale a substantial amount of gold from the government’s reserves. This caused the gold price to plummet, leading to a general crash in the market. Gould and Fisk emerged largely unscathed, but many other investors did not, including the president’s brother-in-law, who had been involved with Gould and Fisk.

A panic in 1873 may have been the first world-wide market crash. This crash was precipitated internationally by the decision of the German government, after the conclusion of the Franco-Prussian war, to abandon silver coinage. There were independent causes in the United States, however. A huge surge in railroad building followed the Civil War, peaking during the period from 1868-1873. Railroad building was capital intensive, but didn’t always lead to prompt profits. Meanwhile, the Government, in response to the German move away from the silver standard, adopted the Coinage Act of 1873. The Act reduced the role of silver in coinage, thereby depressing the price of silver. This damaged mining operations in the west, and caused interest rates to rise. Rising rates led to the inability of investment banks to sell Northern Pacific Railroad bonds, a mechanism to finance that railroad’s transcontinental route. As a result, one of the premier investment banking firms of the day, Jay Cooke & Co., failed, leading to the collapse of smaller firms, a crash in the market, and a prolonged period of economic difficulty.

The most famous crash of the New York Stock Exchange occurred in October, 1929. During the “Roaring Twenties,” margin buying of stocks had pumped up stock prices. A nearly-penniless buyer could buy a few shares of stock, then use those shares as collateral to borrow money to buy additional shares, which he would then use as collateral to buy more. In this manner, shoeshine boys became paper millionaires. However, in such an environment, a relatively small drop in share prices had the potential to unhinge the entire system, and that is largely what happened. When stock prices sagged in the fall of 1929, stock at reduced prices no longer provided adequate collateral for loans, and lenders demanded additional collateral or the repayment of loans. Borrowers were forced to sell shares to “cover” the loans, which put additional downward pressure on prices. The resulting collapse cost the market a large percentage of its value and helped lead to the Great Depression, which lasted until the beginning of World War II.

Perhaps the most recent major crash occurred in September, 2008. Banks had packaged groups of subprime home loans as securities. But the housing “bubble” in the American housing market burst, putting these securities at enormous risk. A major investment banking firm, Lehman Brothers, failed, and many other American and international banks were threatened. The United States Government and the Federal Reserve Bank of the United States intervened to stabilize the market, but an international period of financial instability followed.

 

Famous Figures in Market History

 

Throughout the history of the market, fortunes have been made and lost not only in bull markets but in bear markets as well. If a stock speculator can anticipate the market, he may opt to sell shares at the crest, hold the money, then buy those shares back when the crash or bull market bottoms out. This technique was employed by Jesse livermore in the panic of 1907, earning him a fortune of $3 million, which he thereafter lost. However, he made his fortune back, and then some, in the crash of 1929, which left him with a $100 million fortune — which he also lost. Livermore committed suicide in 1940. Also in the 1907 crash, Bernard Baruch made a significant fortune. Subsequently, however, Baruch became most famous as an adviser on economic matters to several presidents, particularly Presidents Wilson and Franklin D. Roosevelt, and as a philanthropist.

The Witch of Wall Street

Hetty Green, The Witch of Wall Street

Perhaps the first, and certainly one of the best known, women who made a major early impact on the American stock market was Hetty Green, often called “the Witch of Wall Street.” Green began life well to do, but made a much larger fortune, among other things speculating in American currency from her London residence after the Civil War, and investing in railroads. She was renowned as a conservative investor who never borrowed money — but also as a legendary skinflint who some said never washed her clothing till it wore out, and who used neither heat in her house, nor hot water. When she died in 1916, she left a fortune estimated to be $100 million to her son who, despite his spendthrift tendencies, never managed to spend a significant portion of the wealth he inherited from his monther.

Another person who has had perhaps the greatest impact on today’s market was Benjamin Graham. Graham made significant money in the market as a young man, but more importantly, he developed a theory called “value investing.” Graham believed that a true investor seeks to buy stock in companies whose share price is low based on the long-term profitability and prospects of the company itself; he considered all other investing strategies to be speculation. Graham taught this theory at Columbia University, and wrote two important books, Security Analysis (1934) and The Intelligent Investor (1949). The advocates of Graham’s approach include Walter Schloss, Irvimg Khan and others.

Probably the most renowned of Graham’s followers is Warren Buffett, the Omaha-based billionaire who is one of the world’s wealthiest people. In the early sixties, Buffett began buying stock in Berkshire-Hathaway, Inc., and eventually gained control of the company. He used its insurance operations as a vehicle for investment, and did so very successfully. Over time, Berkshire Hathaway became not only a shareholder in companies but began buying whole companies. From 2000-2010, while the S & P 500 averaged a return of -11.2%, Berkshire Hathaway’s return was 76%. Partly as a consequence, other investors often follow Buffett’s moves. Buffett has described Benjamin Graham as the second most influential person in his life after his father, and named his son Howard Graham Buffett. Buffett’s sucess has earned him the nickname, “The Oracle of Omaha.”

 The Stock Market Today

 

Over the years, many reforms have been adopted to attempt to remedy perceived problems with the stock market and its operations. The Securities Exchange Act of 1934 was a response to the 1929 crash. It limited margin trading and established a commission to oversee markets. The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 imposed new regulations on almost every segment of the financial sector in response to the market crash of 2008 and the subsequent recession. But as long as people keep making vast fortunes in the market, it seems likely that there will always be another Jay Gould or another Jesse Livermore who will find a way, within the rules, to make a fortune. And it also seems likely that market cycles will continue to respond to the economy as a whole.

The Trading Lessons of Jesse Livermore – The Great Bear

The Trading Lessons of Jesse Livermore – The Great Bear

At the beginning of the year, I like to return to the fundamentals of trading to refresh my mind and skills on the basics of intelligent speculation in the markets to prepare for the upcoming year.  And, each time I go back to re-familiarize myself with the basics, I also go back and study the Masters that blazed the trail to successful trading with their own unique combination of techniques and mindsets that form the basis of their tremendous success and wealth.

One of them, possibly the greatest trader of all time was Jesse Livermore, also dubbed the Great Bear.

The Great Bear of Wall Street

Jesse Livermore, The Great Bear of Wall Street, has been considered by many as the greatest trader who ever lived whose trading lessons hold something valuable for every trader of ever skill level.

Livermore was a product of turn-of-the-century America in the early 1900s.  Born into a proud, but poor, New England family, Livermore grew up in rural North America in humble circumstances.

Like many fathers of that era, Livermore’s father thought that his son was fated to follow in his footsteps as a farmer and laborer and began to prepare his son for the same way of life that he had led, but his mother had different plans.

At 14, Livermore’s mother thought her son was destined for more than his father’s limited vision for his son could allow him to foresee.  And, one morning, she took her son, put him on a wagon with just $5 in his pocket and sent him to New York.

There was no great plan that she had for him when he arrived in New York but just that his fate would find him once he escaped his current surroundings.

First Trading Lessons

Soon after his arrival, he found employment in the “Buck Shops” of New York, where the Everyday Man could walk in and place on stock almost like placing a bet at horsetrack.

The young Livermore was a keen observer of human behavior and began studying the investors/players who frequented the Bucket Shop he worked in and took note of their winning characteristics as well as the losing characteristics and later modeled those behaviors and winning methods into a sizable stake with his savings made from work.

Still, he wasn’t infallible as he lost his winnings but he never ceased to learn and study the art of stock trading.

Eventually, he leveraged those trading lessons into a sizable stake that let him escape the menial job he had found in the Bucket Shop and became a renowned speculator in the futures and stock market.

He became a millionaire several times over while also managing to go broke several times over (it is believed that he suffered from depression but, at that time, no one knew that it could be a chronic disease and is also believed to have resulted in his financial mistakes as he was not in a peak state of mind compared to when he was at his peak performance) but always came back, winning his losses back plus more.

At the height of his full powers, Livermore timed the Crash of 1929,which ushered in the Great Depression, making almost $100,000,000 in a single day (the equivalent of just under $13 billion dollars in today’s terms) in the stock market!

Sadly, near the end of his career, the depression that his biographer, Richard Smitten, speculated he suffered from, resulted in his suicide.

His life was paralleled in the book “Reminiscences of a Stock Operator” by Edwin Lefèvre, which has gone to be a classic read by almost every aspiring trader at one time or another.

Studying Livermore’s life gives you the opportunity to model the success of one of the great Trading Masters in history and the  following is an excerpt of an article named, “Nine Lessons From The Greatest Trader Who Ever Lived“, by Steven Crist that succeeds in doing just that.

 

Nine Trading Lessons of the Great Bear

 

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On the school of hard knocks:

The game taught me the game. And it didn’t spare me rod while teaching. It took me five years to learn to play the game intelligently enough to make big money when I was right.

On losing trades:

Losing money is the least of my troubles. A loss never troubles me after I take it. I forget it overnight. But being wrong – not taking the loss – that is what does the damage to the pocket book and to the soul.

On trading the trends:

Disregarding the big swing and trying to jump in and out was fatal to me. Nobody can catch all the fluctuations. In a bull market the game is to buy and hold until you believe the bull market is near its end.

On sticking to his plan:

What beat me was not having brains enough to stick to my own game – that is, to play the market only when I was satisfied that precedents favoured my play. There is the plain fool, who does the wrong thing at all times everywhere, but there is also the Wall Street fool, who thinks he must trade all the time. No man can have adequate reasons for buying or selling stocks daily – or sufficient knowledge to make his play an intelligent play.

On speculation:

If somebody had told me my method would not work, I nevertheless would have tried it out to make sure for myself, for when I am wrong only one thing convinces me of it, and that is, to lose money. And I am only right when I make money. That is speculating.

On respecting the tape:

A speculator must concern himself with making money out of the market and not with insisting that the tape must agree with him. Never argue with it or ask for reasons or explanations.

On human nature and trading:

The speculator’s deadly enemies are: Ignorance, greed, fear and hope. All the statute books in the world and all the rule books on all the Exchanges of the earth cannot eliminate these from the human animal.

On riding the trend to the big money:

Men who can both be right and sit tight are uncommon. I found it one of the hardest things to learn. But it is only after a stock operator has firmly grasped this that he can make big money. It is literally true that millions come easier to a trader after he knows how to trade than hundreds did in the days of his ignorance.

On the nature of Wall Street:

Wall Street never changes, the pockets change, the suckers change, the stocks change, but Wall Street never changes, because human nature never changes.

So, what ever happened to Jesse L. Livermore?

He didn’t die a poor man – not by any stretch of the imagination.

But he did take his own life, believing he was “a failure,” which proves once again that money can’t buy happiness.

(click here if you want to read the entirety of this excellent article on Jesse Livermore)

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Livermore’s career is worth studying not just because of the incredible success and wealth that he amassed by trading stocks and futures  but also because he learned early on that trading requires tremendous discipline, emotional balance, and mental tenacity.  It also shows you the great deal of honest that he confronted himself with by taking responsibility for his losses and extracting the lessons that those losses offered.

Whatever your level of skill or experience in trading, the study of Jesse Livermore’s methods and hard-won lessons will prove invaluable to you.