The New Market Wizards: Conversations with America's Top Traders (61 page)

Advance/decline line.
The cumulative total of the daily difference between the number of New York Stock Exchange stocks advancing and the number declining. Divergences between the advance/decline line and the market averages, such as the Dow Jones Industrial Average (DJIA), can sometimes be viewed as a market signal. For example, if after a decline the DJIA rebounds to a new high but the advance/decline line fails to follow suit, such price action may be reflective of internal market weakness.

Arbitrage.
The implementation of purchases in one market against equivalent sales in a closely related market based on the price relationship between the two being viewed as out of line.

Arbitrageurs.
Traders who specialize in arbitrage. Arbitrageurs seek to make small profits from temporary distortions in the price relationships between related markets, as opposed to attempting to profit from correct projections of market direction.

Averaging losers (averaging down).
Adding to a losing position after an adverse price move.

Bear.
Someone who believes that prices will decline.

Bear market.
A market characterized by declining prices.

Boiler room operation.
An illegal or quasilegal phone sales operation in which high-pressure tactics are used to sell financial instruments or commodities at excessive prices or inflated commissions to unsophisticated investors. For example, contracts for precious metals (or options on precious metals) might be sold at prices far above levels prevailing at organized exchanges. In some cases, such operations are complete frauds, as the contracts sold are purely fictitious.

Breakout.
A price movement beyond a previous high (or low) or outside the boundaries of a preceding price consolidation.

Bull.
Someone who believes that prices will rise.

Bull market.
A market characterized by rising prices.

Call option.
A contract that gives the buyer the right—hut not the obligation—to purchase the underlying financial instrument or commodity at a specified price for a given period of time.

Chart.
A graph that depicts the price movement of a given market. The most common type of chart is the
daily bar chart,
which denotes each day’s high, low, and close for a given market with a single bar.

Chart analysis.
The study of price charts in an effort to find patterns that in the past preceded price advances or declines. The basic concept is that the development of similar patterns in a current market can signal a probable market move in the same direction. Practitioners of chart analysis are often referred to as
chartists
or
technicians.

Congestion.
See
Consolidation.

Consolidation.
A price pattern characterized by extended sideways movement. (Also known as
Congestion.
)

Contract.
In futures markets, a standardized traded instrument that specifies the quantity and quality of a commodity (or financial asset) for delivery (or cash settlement) at a specified future date.

Contrarian.
One who trades on contrary opinion (see next item).

Contrary opinion.
The general theory that one can profit by doing the opposite of the majority of traders. The basic concept is that if a large majority of traders are bullish, it implies that most market participants who believe prices are going higher are already long, and hence the path of least resistance is down. An analogous line of reasoning would apply when most traders are bearish. Contrary opinion numbers are provided by various services that survey traders, market letters, or trading advisors.

Cover.
To liquidate an existing position (i.e., sell if one is long: buy if one is short).

Day trade.
A trade that is liquidated on the same day it is initiated.

Discretionary trader.
In a general sense, a trader who has the power of attorney to execute trades for customer accounts without prior approval. However, the term is often used in a more specific sense to indicate a trader who makes decisions based on his own interpretation of the market, rather than in response to signals generated by a computerized system.

Divergence.
The failure of a market or indicator to follow suit when a related market or indicator sets a new high or low. Some analysts look for divergences as signals of impending market tops and bottoms.

Diversification.
Trading many different markets in an effort to reduce risk.

Downtrend.
A general tendency for declining prices in a given market.

Drawdown.
The equity reduction in an account. The
maximum drawdown
is the largest difference between a relative equity peak and any subsequent equity low. Low drawdowns are a desirable performance feature for a trader or a trading system.

Earnings per share (EPS).
A company’s total after-tax profits divided by the number of common shares outstanding.

Elliott Wave analysis.
A method of market analysis based on the theories of Ralph Nelson Elliott. Although relatively complex, the basic theory is based on the concept that markets move in waves, forming a general pattern of five waves (or market legs) in the direction of the main trend, followed by three corrective waves in the opposite direction. One aspect of the theory is that each of these waves can be broken down into five or three smaller waves and is itself a segment of a still larger wave.

Equity.
The total dollar value of an account.

Fade.
To trade in the opposite direction of a market signal (or analyst). For example, a trader who goes short after prices penetrate the upside of a prior consolidation—a price development that most technically oriented traders would interpret as a signal to buy or stay long—can be said to be fading the price breakout.

False breakout.
A short-lived price move that penetrates a prior high or low before succumbing to a pronounced price move in the opposite direction. For example, if the price of a stock that has traded between $18 and $20 for six months rises to $21 and then quickly falls below $18, the move to $21 can be termed a false breakout.

Federal Reserve Board (Fed).
The governing arm of the Federal Reserve System, which seeks to regulate the economy through the implementation of monetary policy.

Fibonacci retracements.
The concept that retracements of prior trends will often approximate 38.2 percent and 61.8 percent—numbers derived from the Fibonacci sequence (see next item).

Fibonacci sequence.
A sequence of numbers that begins with 1,1 and progresses to infinity, with each number in the sequence equal to the sum of the preceding two numbers. Thus, the initial numbers in the sequence would be 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, etc. The ratio of consecutive numbers in the sequence converges to 0.618 as the numbers get larger. The ratio of alternate numbers in the sequence (for example, 21 and 55) converges to 0.382 as the numbers get larger. These two ratios—0.618 and 0.382—are commonly used to project retracements of prior price swings.

Floor trader.
A member of the exchange who trades on the floor for personal profit.

Frontrunning.
The unethical—and in some cases illegal—practice of a broker placing his own order in front of a customer order that he anticipates will move the market.

Fundamental analysis.
The use of economic data to forecast prices. For example, fundamental analysis of a currency might focus on such items as relative inflation rates, relative interest rates, relative economic growth rates, and political factors.

Futures.
See “Futures—Understanding the Basics.”

Gann analysis.
Market analysis based on a variety of technical concepts developed by William Gann, a famous stock and commodity trader during the first half of the twentieth century.

Gap.
A price zone at which no trades occur. For example, if a market that has previously traded at a high of $20 opens at $22 on the following day and moves steadily higher, the price zone between $20 and $22 is referred to as a gap.

Hedge.
A position (or the implementation of a position) used to offset inventory risk or risk related to an anticipated future purchase or sale. An example of a hedge trade is a corn farmer who, during the growing season, sells corn futures with a delivery date subsequent to his anticipated harvest. In this illustration, the sale of futures effectively locks in an approximate future sales price, thereby limiting risk exposure to subsequent price fluctuations.

Hedger.
A market participant who implements a position to reduce price risk. The hedger’s risk position is exactly opposite that of the speculator, who accepts risk in implementing positions to profit from anticipated price moves.

Implied volatility.
The market’s expectation of future price volatility as implied by prevailing option prices.

Leverage.
The ability to control a dollar amount of a commodity or financial instrument greater than the amount of capital employed. The greater the leverage of the position, the greater the potential profit or loss.

Limit position.
A maximum position size (i.e., number of contracts) that a speculator may hold. For many futures contracts, government regulations specify this limit.

Limit price move.
For many futures contracts, the exchanges specify a maximum amount by which the price can change on a single day. A market that increases in price by this specified maximum is said to be
limit-up,
while a market that declines by the maximum is said to be
limit-down.
In cases in which free market forces would normally seek an equilibrium price outside the range of boundaries implied by the limit, the market will simply move to the limit and virtually cease to trade. For an advancing market, such a situation is referred to as
locked limit-up
or
limit-bid;
for a declining market, the analogous terms are
locked limit-down
or
limit-offered.

Liquidity.
The degree to which a given market is liquid.

Liquid market.
A market in which there is a sufficiently large number of trades daily so that most reasonably sized buy and sell orders can be executed without significantly moving prices. In other words, a liquid market allows the trader relative ease of entry and exit.

Local.
A synonym for
Floor trader,
typically used to connote an exchange member who trades for his or her own account.

Long.
A position established with a buy order, which profits in a rising price market. The term is also used to refer to the person or entity holding such a position.

Lot.
In futures markets, another name for contract.

Mark to the market.
The valuation of open positions at prevailing settlement prices. In other words, if a position is marked to the market, there is no distinction between realized and unrealized losses (or gains).

Mechanical system.
A trading system (usually computerized) that generates buy and sell signals. A mechanical system trader follows the signals of such a system without regard to personal market assessments.

Money management.
The use of various methods of risk control in trading.

Moving average.
A method of smoothing prices to more easily discern market trends. A
simple moving average
is the average price during the most recent fixed number of days. Crossovers (one series moving from below to above another, or vice versa) of price and a moving average—or of two different moving averages—are used as buy and sell signals in some simple trend-following systems.

Naked option.
A short option position by a trader who does not own the underlying commodity or financial instrument.

Open interest.
In futures markets, the total number of open long and short positions are always equal. This total (long or short) is called the open interest. By definition, when a contract month first begins trading, the open interest is zero. The open interest then builds to a peak and declines as positions are liquidated approaching its expiration date.

Options.
See the Appendix.

Outright position.
A net long or short position (as opposed to spreads and arbitrage trades, in which positions are counterbalanced by opposite positions in related instruments).

Overbought/oversold indicator.
A technical indicator that attempts to define when prices have risen (declined) too far, too fast, and hence are vulnerable to a reaction in the opposite direction. The concept of overbought/oversold is also often used in association with contrary opinion to describe when a large majority of traders are bullish or bearish.

P and L.
Shorthand for profit/loss.

Pattern recognition.
A price-forecasting method that uses historical chart patterns to draw analogies to current situations.

Pit.
The area where a futures contract is traded on the exchange floor. Also sometimes called the
Ring
.

Position limit.
See
Limit position
.

Price/earnings (P/E) ratio.
The price of a stock divided by the company’s annual earnings.