Trading Definition of Important Terms
by Ian Harvey
On this page you will find the trading definition of key terms made simple. There are no long-winded technical explanations- this is Stock Options Made Easy!
I have explained the terms as I perceive them, and as I apply them to my daily trading practice. This works extremely well for me and it can work for you too.
Stocks and Shares
A stock is the collective term for all the shares in one entity.
A share simply means owning a part of a business (corporation or company).
Therefore, you own shares in a specific stock.
When you buy an option, you are placing a bid on whether a share price will increase (this is called a call option), or decrease (a put option).
A lower amount of money is required to buy into options than shares, but the risk can be higher. A higher risk does bring an increased chance of a bigger profit though, so don’t be afraid to take some calculated chances.
Options do offer a much higher potential return in a shorter time than most stocks.
Buying an option entails buying ‘lots’ of 100. This means that if the price of an option is $1.00, it will cost you $100.00 to buy in.
Options expire on the 3rd Friday of each month. This means that you generally have to sell your options before the expiry date, or risk losing your investment.
When you predict a share will increase in value, the option you would buy is called a call option. See the diagram below.
A put option can be purchased when research indicates that a share will decrease in value. See chart below.
This is the type of trading where you buy and then sell shares and/or options in the same day.
The requirement for day-trading is that your account balance is maintained at a minimum of USD25 000. You must maintain this balance in the account in order to keep trading.
If you are day-trading, the trading definition is that you are a 'day-trader.'
A trading strategy that identifies stocks trading in channels.
By finding major support and resistance levels with technical analysis, a a range-bound trader (or a trend trader) buys stocks at the lower level of support (bottom of the channel) and sells them near resistance (top of the channel).
See Strategies for a Range-bound Market! for further in-depth information.
Trading range-bound stock can be great short term money making opportunity by shorting and going long within the range.
The range-bound trader may repeat the process of buying at support and selling at resistance many times until the stock breaks out of the channel. The upper boundary of the channel is shown by a trendline that connects the points representing a stock's highs over a given time period. The lower boundary of the channel is identified by connecting the points representing a stock's lows.
The downside of this strategy is that when a stock breaks out of the channel, it usually experiences a large price movement in the direction of the breakout. If the breakout direction is not favorable for the trader's position, he or she could lose badly.
Range trading is a non-directional strategy which is based on the underlying assumption that 80% of the time, price action does not trend, but rather channels. Range trading offers several advantages including simplicity, and defined risk reward parameters.
Backwardation is a theory developed in respect to the price of a futures contract and the contract's time to expire.
Backwardation says that as the contract approaches expiration, the futures contract will trade at a higher price compared to when the contract was further away from expiration. This is said to occur due to the convenience yield being higher than the prevailing risk free rate.
How this Works
When backwardation does occur in a futures market it has been suggested that an individual in the short position would benefit the most by delivering as late as possible.
Backwardation in futures contracts was called "normal backwardation" by economist John Maynard Keynes. This is because he believed that a price movement like the one suggested by backwardation was not random but consistent with the prevailing market conditions.
Backwardation is the opposite of contango.
Contango refers to the market condition wherein the price of a forward or futures contract is trading above the expected spot price at contract maturity. The resulting futures or forward curve would typically be upward sloping (i.e. "normal"), since contracts for further dates would typically trade at even higher prices.
The graph depicts how the price of a single forward contract will behave through time in relation to the expected future price at any point time. A contract in contango will decrease in value until it equals the spot price of the underlying at maturity. Note that this graph does not show the forward curve (which plots against maturities on the horizontal).
An Example of Contango
Suppose we enter into a Dec 2011 utures contract, today, for $100. Now go forward one month. The same Dec 2011 future contract could still be $100. But it might also have increased to $110 (this implies normal backwardation) or it might have decreased to $90 (implies contango). The definitions are as follows:
• Contango is when the futures price is above the expected future spot price. Because the futures price must converge on the expected future spot price, contango implies that futures prices are falling over time as new information brings them into line with the expected future spot price.
• Normal backwardation is when the futures price is below the expected future spot price. This is desirable for speculators who are "net long" in their positions: they want the futures price to increase. So, normal backwardation is when the futures prices are increasing.
Consider a futures contract that we purchase today, due in exactly one year. Assume the expected future spot price is $60 (see the blue flat line in Figure 2 below). If today's cost for the one-year futures contract is $90 (the red line), the futures price is above the expected future spot price. This is a contango scenario. Unless the expected future spot price changes, the contract price must drop. If we go forward in time one month, note that we will be referring to an 11-month contract; in six months, it will be a six-month contract.
Clearly, it is more precise to say that in contango, futures prices for a given maturity date are falling. In normal backwardation, futures are rising. This is not exactly the same as the shape of the futures curve because futures prices are constantly adjusting to consensus expectations about the expected future spot price.
A bearish cross is a trend indicated by a large candlestick followed by a much smaller candlestick where the body is located within the vertical range of the larger candle's body. Such a pattern is an indication that the previous upward trend is coming to an end.
A bearish cross may be formed from a combination of a large white or black candlestick and a smaller white or black candlestick. The smaller the second candlestick the more likely the reversal of the direction is to occur. It is thought to be a strong sign that a trend is ending when a large white candle stick is followed by a small black candlestick.
The Wilshire 5000 Total Market Index
The Wilshire 5000 Total Market Index represents the broadest index for the U.S. equity market, measuring the performance of all U.S. equity securities with readily available price data.
The Wilshire 5000 Total Market Index (NASDAQ: W5000), or more simply the Wilshire 5000, is a market-capitalization-weighted index of the market value of all stocks actively traded in the United States. Currently, the index contains over 4,100 components. The index is intended to measure the performance of most publicly traded companies headquartered in the United States, with readily available price data, (Bulletin Board/penny stocks and stocks of extremely small companies are excluded). Hence, the index includes a majority of the common stocks and REITs traded primarily through New York Stock Exchange, NASDAQ, or the American Stock Exchange. Limited Partnerships and ADRs are not included. It can be tracked by following the ticker W5000.
Long-Term Equity Anticipation Securities - LEAPS
Long-Term Equity Anticipation Securities, better known as LEAPS, are publicly traded options contracts with expiration dates that are longer than one year. Actually, they are long term options with expiration of up to 39 months that expires every January of the year.
Structurally, LEAPS are no different than short-term options, but the later expiration dates offer the opportunity for long-term investors to gain exposure to prolonged price changes without needing to use a combination of shorter-term option contracts.
The premiums for LEAPs are higher than for standard options in the same stock because the increased expiration date gives the underlying asset more time to make a substantial move and for the investor to make a healthy profit.
LEAPS are an excellent way for a longer-term trader to gain exposure to a prolonged trend in a given security without having to roll several short-term contracts together. The ability to buy a call/put option that expires one or two years in the future is very alluring because it gives the holder exposure to the long-term price movement without the need to invest the larger amount of capital that would be required to own the underlying asset outright.
These long-term options can be purchased not only for individual stocks, but also for equity indexes (such as the S&P 500).
An options or futures spread established by simultaneously entering a long and short position on the same underlying asset but with different delivery months.
Calendar Spread Option Strategy
When you are fairly neutral on the market and you want to generate additional income from your investments, this option strategy is worth consideration. This strategy involves selling an option with a nearby expiration, against the purchase of an option (with the same strike price) which has an expiration date that is further out.
A Calendar Spread is an option spread where the strike prices are the same, but they have different expiration dates. These spreads are also referred to as horizontal spreads or time spreads.
Calendar spreads can provide a way to add value to your portfolio through your purchase of a long term option with a reduced cost basis, provided by a near term option that you sold.
An Example of a Calendar Spread
An example of a calendar spread would be going long on a crude oil futures contract with delivery next month and going short on a crude oil futures contract whose delivery is in six months.
“Credit spread” is an options strategy where a high premium option is sold and a low premium option is bought on the same underlying security.
A More In-depth Explanation
They are called such because when they are created, they put a "credit" into your trading account, as opposed to a "debit" which normally occurs when you are paying for a stock or its derivative. If, by the time the options in the credit spread expire, the share price hasn't breached a certain level; you get to keep the "credited" funds.
The reason it creates a credit and not a debit, is because you're SELLING an option at a strike price which is closer to the current share price, but so as not to leave yourself exposed, you limit your risk by BUYING the same number of option contracts at a strike price further away, both having the same expiry date. The "sold" option, being closer to "the money" (share price), is more valuable than the "bought" option and so you receive a credit.
The trick here is to open the spread with a short time to expiry, thus taking advantage of the "time decay" factor in options. Options have a time decay which falls away exponentially the closer the expiry date approaches, so creating a credit spread with a maximum 4-6 weeks to expiry is where we want to be. Sometimes you can even enter with under 2 weeks to expiry and keep your credit much quicker, but you need to be more certain about the short term direction the share will move to do this, because your time frame is shorter.
A “credit spread” can also be called a "credit spread option" or “credit risk option".
An example would be buying a Jan 50 call on ABC for $2, and writing a Jan 45 call on ABC for $5. The net amount received (credit) is $3. The investor will profit if the spread narrows.
Credit Suisse is one of Switzerland's top financial services groups, though a distant second to behemoth rival firm UBS.
The group provides investment management, private banking, and asset management services to clients around the world. Investment banking offerings include debt and equity underwriting, M&A advisory, and other securities services.
The group provides wealth management services in Switzerland through subsidiary Clariden Leu; internationally, it operates under the Credit Suisse brand.
Credit Suisse offers asset management services to individual, institutional, and government clients. The group has more than 250 retail branches in Switzerland and operates in more than 50 countries.
Real Time Streaming
This refers to continuous ‘live’ display of stock and options quotes.
Real Time Streaming shows all stock prices from the major American Stock Exchanges.
When the market opens above (or below) the value area and does not get inside the value area.
When the market opens and stays above the value area, this is a strong bullish signal. When this happens, you have dealer and institutional buying going on in the market. When the dealers and institutions are long, you don't want to put on a position opposite of what they are doing. The best chance to profit on a day like this will be from the long side. Buying breaks (dips in the market) to get long will be the best strategy. In fact, when the market has opened above and stays above the value area, you should be afraid of being short.
When the market opens and stays below the value area, this is a strong bearish signal. When this happens, you have dealer and institutional selling going on in the market. When the dealers are short, you don't want to put on a position opposite of what they are doing. The best chance to profit on a day like this will be from the short side. Selling rallies to get short will be the best strategy. In fact, when the market has opened below and stays below the value area, you should be afraid of being long.
The opposite of initiating activity. When the market is above (or below) the value area and does get into the value area.
When the market opens below the value area and buying starts coming into the market (in other words, the market starts moving higher when it is below the value area.) Buyers are "responding" to the market being below the value area and they are attempting to buy the market cheap, thus pushing the market back towards the value area. When we get responsive buying in the market, there is a good chance we will see the 80% rule come into play.
When the market opens above the value area and selling starts coming into the market (in other words, the market starts moving lower when it is above the value area.) Sellers are "responding" to the market being above the value area and they are attempting to sell the market at higher prices than yesterday. When we get responsive selling in the market, there is a good chance that we will see the 80% rule come into play.
Averaging down refers to when an investor buys additional shares of an asset at a lower price than what they originally paid. This is done to lower the overall "average price" of their position.
Here's an example:
Joe Smith buys 1,000 shares of Microsoft at $25.00 per share. He believes in the direction of the company and has a great deal of confidence in management.
The market’s plunge, and Microsoft trades down to $20.00 per share. Joe Smith believes that the fundamentals in Microsoft have not changed, so he decides to buy another 1,000 shares of the company at $20 per share.
Joe Smith has "averaged down" on his Microsoft position - he now owns 2,000 shares of the company at an average of $22.50 per share, instead of 1,000 shares at an average of $25 per share. Joe will now break even at $22.50 per share, but he owns double the shares.
Take Note: Always have plans in place if you are planning on averaging down.
Sometimes this is a good strategy, other times it's better to sell off a beaten down stock rather than buying more shares.
Many people will average down in a stock because they are just too stubborn to take a loss - this is a sure recipe for disaster.
Pyramiding is an old trading strategy where a speculator adds to their position size by using margin from unrealized gains. This trading strategy is based solely on the power of using leverage and was made popular by one of the greatest traders of all-time, Jesse Livermore.
In other words, an investor who is pyramiding uses excess margin from the increasing price of a security in his or her portfolio to purchase more of the same security. This is generally a slow method of increasing one's position size as the margin increases will permit successively smaller purchases.
Example of a Pyramiding Strategy
A pyramiding strategy is considered a risky investment approach, but with proper money management can produce stellar results.
When the market took a nose dive, with little or no retracements, if a trader was short, this kind of market environment would have been a prime candidate for a number or pyramiding strategies.
In the chart below, Citigroup took a beating from a swing high of $49 in early October to a low of $3 in November. In a pyramiding strategy a trader will want to add to their positions on each bounce.
So, in the example below, when the stock fell from $49 and then had a short rally up to $35, this would represent a 29% drop, which on margin would be a 58% gain on your cash. This additional 29% of paper profits would then be used to add to the short position at $35 for the ride down.
This process of adding to the short position would have continued all the way down to $3. Which would have produced much greater returns than simply shorting the stock at $45 and riding it down to $3.
Problems Associated with Pyramiding
Pyramiding will only work properly in a trending market. This is because if you are trading in a choppy market, the short-term corrections will naturally float towards previous swing points, thus eating into your original gains. So, remember to only consider such a trading strategy when both the markets and stocks are trending heavily in one direction.
The technical range between support and resistance levels that a stock price has traded in for a specific period of time. Channel traders capitalize on the tendencies of markets to trend.
In the context of technical analysis, a channel is defined as the area between two parallel trendlines and is often taken as a measure of a trading range. The upper trendline connects price peaks (highs) or closes, and the lower trendline connects lows or closes. An example of a channel is shown below. Breakout points in channels indicate bullish (on upward trends) or bearish (on downward trends) signals.
1. Channels are useful for short-to medium-term trading - not long-term trading or investing. The technique often works best on stocks with a medium amount of volatility. Remember, the volatility determines your profit per trade. Channeling also tends to work best when the technique is combined with other forms of technical analysis, at which we take a closer look below.
2. A breakout of a technical channel is seen as a bullish (on an upward breakout) or bearish signal (on a downward breakout).
Stoxx is a series of market indexes that are representative of the European and global markets. These indexes cover a wide range of market segments including the broad market, blue chips, individual sectors and global indexes. While there are global STOXX indexes, the majority of the focus is placed on the European market.
The STOXX indexes were created out of a venture between Dow Jones, Deutsche Boerse AG, and the SWX group. These indexes are tradable on the futures and options market and are also used as benchmarks for funds that trade in the European and global markets. The Dow Jones Industrial Average in the U.S. is similar to the Dow Jones STOXX 50 Index.
Dow Jones EURO STOXX 50 Index
This is a market capitalization-weighted stock index of 50 large, blue-chip European companies operating within eurozone nations. The universe for selection is found within the 18 Dow Jones EURO STOXX Supersector indexes, from which members are ranked by size and placed on a selection list.
The largest 40 stocks on the selection list are automatically chosen for the EURO STOXX 50. Any grandfathered index components receive next priority, then stocks ranked between 41 and 60 are chosen to reach the final number of 50 stocks in the index. The index is reconstituted annually and the weightings updated once per quarter to account for changes in market caps.
The EURO STOXX 50 closely resembles the Dow Jones STOXX 50 in methodology and construction, with the exception that only companies who have fully transitioned to the euro currency can be members of the EURO STOXX 50. As such, U.K.-based companies are excluded even though many large multinationals trade on the London Stock Exchange.
The Dow Jones STOXX 50 Index
A stock index representing 50 of the largest companies in Europe based on market capitalization. The stock universe used for selection is an aggregate of the 18 Dow Jones STOXX 600 Supersector indexes, which together capture about 95% of the capitalization of the major stock exchanges in 18 European countries. Each sub-index places its largest members placed on a selection list, which is then ranked by market cap to choose the STOXX 50 members.
The index, first reported in 1998, is reconstituted annually, and weightings are adjusted quarterly to account for proportional changes in underlying company market caps.
The Dow Jones STOXX 50 index closely resembles the Dow Jones EURO STOXX 50 in methodology and construction, with the exception that it does not limit company selection to companies that have fully transitioned to the euro currency.
The index limits the weighting of any one member to 10%, but no sector limitations are applied to the index's construction. As such, banking companies dominate the STOXX 50. The index is meant to capture blue-chip companies in the region, so the average market cap is large.
MSCI All-Country World Index
A market capitalization weighted index designed to provide a broad measure of equity-market performance throughout the world. The MSCI ACWI is maintained by Morgan Stanley Capital International, and is comprised of stocks from both developed and emerging markets.
As of January 2009, this index contains stocks from 46 different countries. There are 23 countires classified as developed markets and 23 countries considered emerging markets. Typically the index is built first at the country level, and then the 46 indexes are aggregated into the MSCI All Country World Index. A similar index exists that contains the same countries with the exception of the U.S. - the MSCI ACWI Ex-U.S.
International Monetary Fund - IMF
The IMF is the International Monetary Fund, headquartered in Washington, D.C. It's a global organization made up of 185 member countries, founded in 1944 with the purpose to oversee global financial health and provide assistance when needed to its members.
It is an international organization created for the purpose of:
1. Promoting global monetary and exchange stability.
2. Facilitating the expansion and balanced growth of international trade.
3. Assisting in the establishment of a multilateral system of payments for current transactions.
Today, the IMF states its goals are "to promote international monetary cooperation, exchange stability, and orderly exchange arrangements; to foster economic growth and high levels of employment; and to provide temporary financial assistance to countries to help ease balance of payments adjustment."
EURO STOXX 50 Volatility (VSTOXX)
The VSTOXX Indices are based on EURO STOXX 50 realtime options prices and are designed to reflect the market expectations of near-term up to long-term volatility by measuring the square root of the implied variance across all options of a given time to expiration.
The VSTOXX Indices are part of a consistent family of volatility indices: VSTOXX based on the EURO STOXX 50; VDAX-NEW based on the DAX; and VSMI based on the SMI.
It is not possible to invest directly into the VSTOXX index as this is a theoretically calculated index and is not tradable. There are however VSTOXX® futures which are tradable; these are traded on Eurex.
Vstoxx Short-Term Futures Index
The VSTOXX Short Term Futures Index is an index that maintains a constant 1 month exposure to VSTOXX Futures. It does this by rolling positions in the first and second month futures each day to keep the exposure constant at 1 month.
The VSTOXX Short-Term Futures Index is calculated and published by STOXX Ltd., however Barclays Capital has exclusive access to the index for 12 months from its creation.
Glocalisation (or glocalization)
Glocalisation is a portmanteau word of globalization and localization.
By definition, the term “glocal” refers to the individual, group, division, unit, organisation, and community which is willing and able to “think globally and act locally.” The term has been used to show the human capacity to bridge scales (local and global) and to help overcome meso-scale, bounded, “little-box” thinking. ‘Glocals’ is a term often used to describe a new social class: expat managers who travel often and switch homes often, and are therefore both global and local.
The term glocalization originated from within Japanese business practices. It comes from the Japanese word dochakuka, which simply means global localization. Originally referring to a way of adapting farming techniques to local conditions, dochakuka evolved into a marketing strategy when Japanese businessmen adopted it in the 1980s.
It was also used in the Global Change Exhibition (opened May 30, 1990) in the German Chancellery in Bonn by Manfred Lange, the director of the touring exhibit development team at that time. He described the interplay of local-regional-global interactions as “glocal”, showing the depth of the space presented and drawn.
The term was popularized in the English-speaking world by the British sociologist Roland Robertson in the 1990s, the Canadian sociologists Keith Hampton and Barry Wellman in the late 1990s, and Zygmunt Bauman. Hampton and Wellman have frequently used the term to refer to people who are actively involved in both local and wider-ranging activities of friendship, kinship and commerce.
Thomas L. Friedman, in "The World is Flat", talks about how the Internet encourages glocalisation, such as encouraging people to make websites in their native languages.
"Glocal" also pops up as a plot motivator in the 2010 film, “Up in the Air” when the career-ending counselors switch from in-person to videoconferencing terminations.
Sector Rotation is the action of a mutual fund or portfolio manager shifting investment assets from one sector of the economy to another.
Not all sectors of the economy perform well at the same time. Sector rotation is a portfolio manager's attempt to profit through timing a particular economic cycle.
Certain sectors of business profit more in certain stages of an economic cycle. This simple arrangement of stages provides a useful road map to traders of most stripes.
Sector rotation, being an investment strategy involving the movement of money from one industry sector to another in an attempt to beat the market, evolved as a theory from the National Bureau of Economic Research (NBER) data on economic cycles dating back to 1854. It's thanks to this cadre of government and academic economists that we know the start, end and duration of each business cycle.
NBER are the ones that announce that a recession has officially ended. The data may be slow to develop, and a bit dry, but a little digging can provide insight that investors can use to make decisions. It's important to remember that past performance in the stock market does not always mean future success, and a particular sector may, or may not, be in favor at any time. That said, let's look at the data that can help investors decide what they should be invested in during any given market cycle.
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