Stock Market Terms
A financial market that dwarfs the world stock markets called Forex (an abbreviation of Foreign Exchange). Forex is a global decentralized stock market that determines the relative value of one currency over another at any given moment. In this blog, we explore the 50+ Stock Market Terms.
Algorithmic Trading: A trading system that utilizes very advanced mathematical models for making transaction decisions in the financial markets. The strict rules built into the model attempt to determine the optimal time for an order to be placed that will cause the least amount of impact on a stock’s price.
Large blocks of shares are usually purchased by dividing the large share block into smaller lots and allowing the complex algorithms to decide when the smaller blocks are to be purchased.
Ask Price: The price a seller is willing to accept for security, also known as the offer price. Along with the price, the ask quote will generally also stipulate the amount of security willing to be sold at that price.
Backtesting: The process of testing a trading strategy on prior time periods. Instead of applying a strategy for the time period forward, which could take years, a trader can do a simulation of his or her trading strategy on relevant past data in order to gauge its effectiveness.
Base Currency: The first currency quoted in a currency pair on forex. It is also typically considered the domestic currency or accounting currency. For accounting purposes, a firm may use the base currency to represent all profits and losses.
Bid Price: An offer made by an investor, a trader or a dealer to buy a security. The bid will stipulate both the price at which the buyer is willing to purchase the security and the quantity to be purchased.
Carry Trade: A strategy in which an investor sells a certain currency with a relatively low-interest rate and uses the funds to purchase a different currency yielding a higher interest rate.
A trader using this strategy attempts to capture the difference between the rates, which can often be substantial, depending on the amount of leverage used.
Commodity Futures Trading Commission (CFTC):
An independent U.S. federal agency established by the Commodity Futures Trading Commission Act of 1974. The Commodity Futures Trading Commission regulates the commodity futures and options markets. Its goals include the promotion of competitive and efficient futures markets and the protection of investors against manipulation, abusive trade practices, and fraud.
Drawdown: The peak-to-trough decline during a specific record period of an investment, fund or commodity. A drawdown is usually quoted as the percentage between the peak and the trough.
Fiat Currency: Currency that a government has declared to be legal tender, but is not backed by a physical commodity. The value of fiat money is derived from the relationship between supply and demand rather than the value of the material that the money is made of.
Historically, most currencies were based on physical commodities such as gold or silver, but fiat money is based solely on faith. Fiat is the Latin word for “it shall be”.
The exchange of one currency for another or the conversion of one currency into another currency. Foreign exchange also refers to the global market where currencies are traded virtually around-the-clock. The term foreign exchange is usually abbreviated as “forex” and occasionally as “FX.”
Forward testing is a simulation of actual trading and involves following the system’s logic forward to gauge its effectiveness in live market conditions.
A method of evaluating a currency that entails attempting to measure its intrinsic value by examining related economic, financial and other qualitative and quantitative factors.
Fundamental analysts attempt to study everything that can affect the currency’s value, including macroeconomic factors (like the overall global economy and conditions) and country-specific factors (like economic and financial conditions).
Geometric Average Holding Period (GHPR): The geometric average return formula is used to calculate the average rate per period on an investment that is compounded over multiple periods. The geometric average return may also be referred to as the geometric mean return.
Gold Standard Currency: A monetary system in which a country’s government allows its currency unit to be freely converted into fixed amounts of gold and vice versa.
The exchange rate under the gold standard monetary system is determined by the economic difference for an ounce of gold between two currencies. The gold standard was mainly used from 1875 to 1914 and also during the interwar years.
High-Frequency Trading (HFT): A program trading platform that uses powerful computers to transact a large number of orders at very fast speeds. High-frequency trading uses complex algorithms to analyze multiple markets and execute orders based on market conditions.
Typically, the traders with the fastest execution speeds will be more profitable than traders with slower execution speeds. As of 2009, it is estimated more than 50% of exchange volume comes from high-frequency trading orders.
The financial system and trading of currencies among banks and financial institutions, excluding retail investors and smaller trading parties. While some interbank trading is performed by banks on behalf of large customers, most interbank trading takes place from the banks’ own accounts.
Leverage: The use of various financial instruments or borrowed capital, such as margin, to increase the potential return of an investment.
Margin: Borrowed money that is used to purchase currencies or equities. This practice is referred to as “buying on margin”.
Margin Call: A broker’s demand on an investor using margin to deposit additional money or securities so that the margin account is brought up to the minimum maintenance margin. Margin calls occur when your account value depresses to a value calculated by the broker’s particular formula.
Momentum Indicator: The Momentum Technical Indicator measures the amount that a security’s price has changed over a given time span.
Moving Average: A widely used indicator in technical analysis that helps smooth out price action by filtering out the “noise” from random price fluctuations. A moving average (MA) is a trend-following or lagging indicator because it is based on past prices.
The two basic and commonly used MAs are the simple moving average (SMA), which is the simple average of a security over a defined number of time periods, and the exponential moving average (EMA).
The most common applications of MAs are to identify the trend direction and to determine support and resistance levels. While MAs are useful enough on their own, they also form the basis for other indicators such as the Moving Average Convergence Divergence (MACD).
National Futures Association (NFA):
The independent self-regulatory organization for the U.S. futures market. NFA membership is mandatory for all participants in the futures market, providing assurance to the investing public that all firms, intermediaries, and associates who conduct business with them on the U.S. futures exchanges must adhere to the same high standards of professional conduct.
The NFA operates at no cost to the taxpayer, as it is financed exclusively by membership dues paid by members and assessment fees paid by users of futures markets. The national headquarters is in Chicago and there is an office in New York.
Net Asset Value (NAV): The balance of deposits, realized and unrealized profit/loss, and interest, minus withdrawals.
Over-the-Counter (OTC) Market:
A security traded in some context other than on a formal exchange such as the NYSE, TSX, AMEX, etc. The phrase “over-the-counter” can be used to refer to stocks that trade via a dealer network as opposed to a centralized exchange.
It also refers to debt securities and other financial instruments such as derivatives, which are traded through a dealer network.
Pip: The smallest price change that a given exchange rate can make. Since most major currency pairs are priced to four decimal places, the smallest change is that of the last decimal point - for most pairs this is the equivalent of 1/100 of one percent or one basis point.
Price Action: The movement of a security’s price. Price action is encompassed in technical and chart pattern analysis, which attempt to find order in the sometimes seemingly random movement of price. Swings (high and low), tests of resistance and consolidation are some examples of price action.
Profitability: A regulation for evaluating whether to proceed with a project or investment. The profitability index rule states:
If the profitability index or ratio is greater than 1, the project is profitable and may receive the green signal to proceed. Conversely, if the profitability ratio or index is below 1, the optimum course of action may be to reject or abandon the project.
The second currency quoted in a currency pair in forex. In a direct quote, the quote currency is the foreign currency. In an indirect quote, the quote currency is the domestic currency.
Investment funds allocated to speculative activity. Risk capital refers to funds used for high-risk, high-reward investments such as junior mining or emerging biotechnology stocks.
Such capital can either earn spectacular returns over a period of time or may dwindle to a fraction of the initial amount invested if several ventures prove unsuccessful. Diversification is key for the successful investment of risk capital. In the context of venture capital, risk capital may also refer to funds invested in a promising start-up.
Risk: Reward Ratio:
A ratio used by many investors to compare the expected returns of an investment to the amount of risk undertaken to capture these returns.
This ratio is calculated mathematically by dividing the amount he or she stands to lose if the price moves in the unexpected direction (i.e. the risk) by the amount of profit the trader expects to have made when the position is closed (i.e. the reward).
The Sharpe ratio is calculated by subtracting the risk-free rate - such as that of the 10-year U.S. Treasury bond - from the rate of return for a portfolio and dividing the result by the standard deviation of the portfolio returns.
Signal: A sign, usually based on technical indicators, that it is a good time to buy or sell a particular security. Trade signals come in a variety of forms, including bull or bear pennants, rectangles, triangles, and wedges, as well as head-and-shoulders chart patterns. Trade signals may also bring attention to abnormal volumes, options activity, and short interest.
Stop Loss: An order placed with a broker to sell a position when it reaches a certain price. A stop-loss order is designed to limit an investor’s loss on a position.
Trader Psychology: The emotions and mental state that dictate success or failure in trading securities. Trading psychology refers to the aspects of an individual’s mental makeup that help determine whether he or she will be successful in buying and selling securities for a profit.
Trading psychology is as important as other attributes such as knowledge, experience, and skill in determining trading success.
Discipline and risk-taking are two of the most critical aspects of trading psychology since a trader’s implementation of these aspects are critical to the success of his or her trading plan.
While fear and greed are the two most commonly known emotions associated with trading psychology, other emotions that drive trading behavior are hope and regret.
Trading the News:
A technique to trade equities, currencies and other financial instruments on the financial markets. Trading news releases can be a significant tool for financial investors. Economic news reports often spur strong short-term moves in the markets, which may create trading opportunities for traders.
Interest rates, unemployment and export rates, or the central bank’s policy shifts can cause a deep change of an exchange rate.
Trailing Indicator: A technical indicator that trails the price action of an underlying asset, and is used by traders to generate transaction signals or to confirm the strength of a given trend.
Since these indicators lag the price of the asset, a significant move will generally occur before the indicator is able to provide a signal.
Trend Reversal: A change in the direction of a price trend. On a price chart, reversals undergo a recognizable change in the price structure. An uptrend, which is a series of higher highs and higher lows, reverses into a downtrend by changing to a series of lower highs and lower lows.
A downtrend, which is a series of lower highs and lower lows, reverses into an uptrend by changing to a series of higher highs and higher lows.
A stock's intrinsic value equals the present value of its dividends, but value investors look beyond dividends to a firm’s earnings and assets.
Earnings are important because these give firms the means to pay dividends, and assets are important because these are the source of earnings. Dividend-price ratios, earnings-price ratios, and asset-price ratios are sensible financial benchmarks, but none are infallible.
THE EARNINGS-PRICE RATIO
A stock’s earnings-price ratio (E/P), or earnings yield, is a rough estimate of a stock’s rate of return. If a stock sells for $100 a share and the company earns $10 a share, it seems as though the shareholders have earned $10, which is a 10 percent return on their investment.
If so, earnings yields should be related closely to the interest rates on Treasury bonds.
A dollar to shareholders, the firm must earn a return equal to the shareholders’ required return. If the firm earns less than the required return, a dollar of retained earnings is worth less than a dollar. If the firm earns more than the required return, a dollar of retained earnings is worth more than a dollar.
This is why Berkshire Hathaway doesn’t pay dividends. Its managers believe that their investments will earn more than their shareholders’ required return.
The more general point is that the earnings-price ratio is an imperfect measure of the stockholders’ return. Earnings are important because they are the source of dividends. However, earnings are the means to the end, not the end itself.
A LOW P/E IS NOT NECESSARILY A BARGAIN
Crane correctly cautioned that “no market is cheap because the price-earnings ratio is low and no market is dear because the ratio is high.” Mechanical rules ignore perfectly logical reasons why individual stocks or the market as a whole may be cheap even if the P/E ratio is high and expensive even though the P/E is low.
The intrinsic value of a stock is higher if earnings (and dividends) are expected to grow faster. Intrinsic values are also higher if interest rates are low. Thus, the market P/E tends to be high when investors are bullish on the economy and/or interest rates are low.
There are two other factors to consider: short-run fluctuations in earnings and creative accounting. If earnings are depressed temporarily by an economic recession or corporate misfortune, a stock’s price may stay relatively firm as current earnings sag, driving the P/E ratio skyward.
In these circumstances, the P/E ratio is unusually high because earnings are abnormally low. In the reverse situation, the P/E will fall if investors perceive a temporary bulge in earnings to be due to extraordinary good luck.
Similarly, if investors believe that the firm has used dubious accounting procedures to boost reported earnings, the P/E ratio will be deceptively small because earnings are fictitiously large.
The bottom line is that there is no reason to think that the market's P/E should be some magic number like 10 or 14.9. There is even less reason to think this should be true of individual stocks.
The Book value of a firm is the net worth shown on the accountants’ books. It is commonly calculated on a per-share basis, total assets minus liabilities, divided by the number of shares outstanding. book values are generally based on the cost of a firm’s assets, depreciated over time for presumed wear and tear.
However, a firm’s value to shareholders is the cash that it generates, not the cost of its assets.
A firm that loses money year after year is of little value to shareholders even if it costs billions to construct its money-losing buildings and equipment. (Imagine a tomato farm on top of Mount Everest.) Conversely, a high-technology company operating out of a garage can be worth millions of dollars even though its garage is only worth thousands.
There is considerable evidence of abnormal returns from “value” stocks that have low prices relative to dividends, earnings, and blog value. Mechanical rules are no guarantee of success, but these valuation metrics have the virtue of cultivating a contrarian approach to investing. Value investing and contrarian investing are often two sides of the same coin.
When investors are fearful and contrarian investors look to pounce, stock prices are low relative to dividends, earnings, and blog value, and these bargain prices attract value investors. Greed, on the other hand, which is a sell sign for contrarian investors, fuels high stock prices that scare off value investors.
Therefore, value strategies must be risky—even if the only evidence we have of their riskiness is that they are profitable. Skeptics dismiss this reasoning as circular and argue that animal spirits and other market noise create profitable opportunities for contrarians and value investors.