Education

Terminology – what is what?

Markets

The FX market is the global currency market for trading currencies. The FX market is the biggest market in the world in terms of total cash value traded where daily transactions reach approximately 5 Trillion USD.

Fixed income are investments where the borrower is obliged to make payments of a fixed amount on a fixed schedule. There are various fixed income products such as government bonds, corporate bonds, junk bonds etc.

Commodities markets consist of soft (wheat, sugar etc) and hard (gold, oil etc) commodities. Futures and other derivatives are used to trade commodities. Commodity ETFs have gained popularity over the past years and provide easy access for traders wishing to trade commodities.

Two concepts specific for commodities markets are contango and backwardation. Contango is a where futures price of a commodity is higher than the anticipated spot price at maturity of the futures contract. Backwardation is where the price of a commodities’ futures contract is trading below the expected spot price at contract maturity.

An ”index” measures the values of a section of the stock market and is often calculated as a weighted average. It is used by investors to compare returns and describe the market.

S&P 500; the S&P 500 is regarded as the single best gauge of US large cap companies and covers approximately 80% of market capitalization.

NASDAQ; the NASDAQ index is the big ”tech” index in the US but also reflects companies across other industries such as; telecommunications, biotechnology etc.

Dow Jones; the ”Dow” index shows how 30 large publicly owned companies based in the United States trade.

Russell 2000; this index is considered the best gauge of the US small cap stocks.

Euro Stoxx 50; the Euro Stoxx 50 index is Europe’s leading blue chip index representing the super sector leaders in the Eurozone. The index represents stocks from 11 countries.

DAX index; the DAX is the German blue chip index representing the 30 major German companies trading on the Frankfurt Stock Exchange.

FTSE 100; the ”footsie” is the index representing the 100 biggest UK companies listed on the London Stock Exchange.

Nikkei 225; more commonly called, the Nikkei, is a stock market index for the Tokyo Stock Exchange.

Hang Seng; the ”HSI” consists of the 50 biggest companies on the Hong Kong stock exchange.

The VIX, CBOE Volatility Index, is the most popular and widespread measure of stock market’s expectations of volatility. The VIX index is calculated by using implied volatilities of a wide range of S&P 500 index options. In media it is often referred to as the fear index. VIX is a mean reversion index since volatility is an asset that over time revert to the mean.

The chart below shows the 5 year chart of VIX index. Note the spikes in volatility and how over time this index reverts to some kind of mean value.

Source: Bloomberg


A few words

A stop loss is an order placed with your broker to execute a trade at a predetermined price in order to minimise the loss. If you are long the stop loss order needs to be a sale of your shares. If you are short the stop loss order will be a buy order.

A take profit order is an order where the trader is willing to take profit by closing out the existing position.

A long is the trader buying a security such as a stock, FX etc with the expectation that the asset will rise in value.

A short is a trade where the investor sells shares of borrowed (from the broker) stock in the open market, ie you need to borrow the share prior to shorting it. Your broker will provide you with a short list which shows what stocks are available for shorting and at what cost. There is a stock borrow market that handles all stock borrows. Normal stock lending is not expensive, but at times specific stock names can get rather expensive to borrow.

The trader with a short stock position expects that the price of the stock will decrease over time. At some point the investor will purchase the shares in the marketplace and return the borrowed shares to the broker. A short stock position benefits from declining prices.

Do note an investor can be long/short options and other instruments where the effect on that instrument might be affected by other aspects than only the underlying stock.

Trend following is an investment strategy based on technical analysis where the belief is an asset moves up or down over time. One of trend following indicators is the MACD. The inverse to trend following investment is the contrarian approach.

Contrarian investing is a strategy defined by the investor buying and selling in opposite direction to the prevailing trend. A contrarian investing strategy is partly based on the view there is a mean reversion of asset prices. Mean reversion is the assumption that a stock’s price tends to move to the average price over a time period.

Arbitrage is the strategy of buying and selling an asset simultaneously in order to profit from differences in the price and by executing these trades the trader ”locks in” a risk free profit. Arbitrage can be simple transactions where the trader buys one share in the local market and at the same time sells it short in another marketplace (an ADR for example) and does the fx conversion. The trader is basically buying and selling the same stock at a price difference. There are complex arbitrage trades involving multiple instruments and markets as well. Quick arbitrage these days is less common and the margins very small. This is a direct effect of computerized trading exploiting these small arbitrage price discrepancies.


Crypto

Cryptocurrency is a ”virtual” currency that uses cryptography to track purchases and transfers. ”Cryptos” have become very popular during the last years and attract a lot of attention from traders and investors. There are several cryptos such as; bitcoin, ethereum, ripple, litecoin etc. Trading in the cryptos has seen large volatility. Cryptos are decentralized and are based on the blockchain technology.

By allowing digital information to be distributed but not copied, Blockchain technology has created the backbone of a new type of internet. Digital information is allowed to be distributed but not copied. The technology was originally devised for digital currency, but the community is finding new potential uses for this technology.

The biggest crypto at the moment, Bitcoin, operates on a technology with no central authority or banks. The network issues Bitcoins and manages all transactions. Nobody controls nor owns Bitcoin. Bitcoin mining is practically the process of solving complex math problems with special software. In exchange for the mining process the miner is issued a certain amount of Bitcoins.

Chart of Bitcoin. Extreme volatility that has attracted many speculators. Note the recent fall below the long term moving average.

Source: Bloomberg

Ethereum is an open software platform based on blockchain technology, just as the above mentioned Bitcoin. The big difference is that while Bitcoin focuses on digital currency, Ethereum focuses on running the programming code of any decentralized application. Miners earn ether, a crypto “token” that helps fuel the network.

Ripple is a digital currency as well as a payments protocol. It is the payments protocol part of Ripple that has got people excited. Very simply put Ripple makes it possible to transmit anything without moving it, as long as both gateways in a transaction are set up to deal in it. It obviously works easiest for assets like cash, cryptos and even gold, but if the gateways are set up you can deal in cars, flowers or anything else.

Litecoin is similar to Bitcoin but differs in aspects such as faster blockchain generation rate and use of scripts as a proof of scripts.


Central Banks

A central bank is an independent national authority that regulates banks, provides financial services and operates monetary policies. The aim of a central bank is to prevent inflation, keep unemployment low and stabilize the nation’s currency. Central banks are also involved in stabilizing markets and some of the central banks like the BoJ and the SNB buy equities and ETFs outright. You might read about the central bank put. This is a term referred to as the protection of the markets with the central banks intervening in order to not let the equities fall sharply. The first central bank was formed in Sweden in 1668.

The Federal Reserve (Fed), founded in 1913, is the central bank of the US and arguably the most powerful financial institution in the world.

The ECB, formed in 1998, is the central bank for the countries of the European union that share the euro currency.

Bank of Japan (BoJ), founded in 1882, is the central bank of Japan.

Below is a chart showing Fed’s total assets. Note how the balance sheet started expanding as Fed started intervening back in 2008 in order to stimulate the economy.

Source: Bloomberg