Because Reading Investopedia Doesn’t Tell You What To do
I have promised to assume no financial knowledge in teaching you all how to trade bubbles, and while Investopedia is a great resource, it doesn’t tell you what to do with the terms they define.
My goal here is to explain concepts in a way that you can use them. That’s why this terminology guide is the most interesting one you will find. Reading it will actually provide you with investment and trading ideas.
Financial Terms for Investing
Here’s what we’ll cover:
- Basic Terms security, asset, bond, stock, market indexes (S&P, DJIA, Nasdaq), ETFs, ETNs, ETPs, investor, trader, speculative positions, market capitalization in stocks, market capitalization in cryptocurrencies
- Up and Down Going long, going short, inverse ETPs, funds and fund Managers, hedging, hedge funds.
- The World of Cryptocurrencies Fiat Currencies, Blockchain, Bitcoin, Ethereum Network and Ether, coins, tokens, Wallets, Exchanges, Third Generation Coins, ICOs
- Multiplying Returns Leverage, average daily balancing, call and put options, a contract, volatility, the VIX and IPOs
1 Basic Terms
Basic Financial Terms for Investing
In general use, it is any kind of traded financial item, including bonds, stocks, ETPs, calls, puts, et cetera (all of these are discussed below). Technically, it’s a fungible (numerically replaceable) and negotiable financial instrument. Given the increasing role of cryptocurrencies, “security” is often used to include these.
A note indicating the obligation of one party (a company) to a lender, with a % every year to be paid, and termination date.
A Share of Stock
A percent (share) ownership in a company (whether the company is publicly traded or not), which indicates how much percentage-wise of the owners’ equity one has.
Examples include the S&P 500, the Dow Jones 30, and the NASDAQ. These are aggregated indexes of a specific set of companies, operating in a specific country (usually), and serve as a measure for how the overall character of the stock market is functioning.
ETP / ETF / ETN
Exchange Traded Product (ETP) is a general term that may indicate either an Exchange Traded Fund (ETF) or an Exchange Traded Note (ETN).
- ETPs mimic various benchmark indexes (say oil prices, or biotech stocks, or volatility), but ETFs do so by actually buying those securities, while ETNs only give notes that would mimic the activity of those securities.
- ETNs make taxes easier, then, but might (and occasionally do) go out of existence if they lose 80% of their value in a day (read the fine print for each).
TRADITIONAL — USE of ETPs
Say that you want just to track whatever the S&P is doing with your retirement savings.
You can’t actually buy the S&P index, but you could buy an ETF that mechanically mimicked what the S&P did (like the GSPC). This is an important idea: you can’t often buy indexes, but only proxies (like ETFs) that mimic their activity. You could buy all 500 companies in the S&P and rebalance daily, but it would be such a huge pain that it’s practically infeasible.
An Investor vs. A Trader
It’s a little arbitrary to distinguish these two styles of “investing.” One way follows from the tax regulations for investing in the United States. In the US, for the present at least, if you hold onto a security for over a year (365 days), the taxes you pay are just capital gains (15%), but if you make money on a shorter time frame, you need to pay at the rate of your income (23%-35%). So let’s just say that an investment is anything you hold for over 365 days, a trade for anything you hold for a shorter time frame.
- Note: I’ll sometimes use “investment” or “be invested” in a way that I really mean just: have a position in some security. Context should easily be able to differentiate this general and loose use from the more specific sense of an investor as opposed to a trader.
A Speculative Position
This would be any trade or investment where either (1) you are unable to put a probability of success on the position, or (2) you are able to do so, but the probability for success is less than 50%. The first, a trade/investment is one done in ignorance; the second is one done with high risk. Trades and investments are not speculative.
Market Capitalization in Stocks
This is just the total value of all the shares of a company (Market Capitalization = price per share x total number of shares).
- If a company has 1,000,000 shares, and they are worth $52 each, then the market capitalization (Market Cap for short) of the company is 52,000,000.
This is one way to think about price for a company. It’s the price of buying the entire company (every share) to become sole owner. The standard quoted price you see in tickers is actually price per share.
- In reality, you’re not going to find anything under 50m for market cap on the stock market, because that’s so small. You can think of company sizes, roughly, in the following way.
- Micro Cap: 50m – 300m
- Small Cap: 301m – 2Billion
- Mid Cap: 2B – 10B
- Large Cap: 10B + Apple (AAPL) is about 1Trillion for reference.
Market Capitalization in Cryptocurrencies
This the price per coin x the total number of coins in existence.
- If a coin is worth $5,200 and there are 100,000 in existence, then the market capitalization would be $5,200,000,000.
- This is used to make apples-to-apples comparisons about how valuable a coin is.
Some people think that because a coin costs $.50 it has “more room to grow” than a coin that is worth $10,000. This is ABSOLUTELY WRONGHEADED.
- Call the $.50 coin Sucker coin and the $10,000 coin Value coin
- If there are 1,000,000,000 Sucker Coins, and only 1000 Value Coins, which one has the bigger market capitalization?
- Answer: Sucker Coin’s market cap is $500,000,000, while Value Coin’s market cap is on fifth that at $10,000,000. Don’t fall for Sucker Coin reasoning!
2 Up and Down
means that you are invested in such a way that you will make money if the underlying security increases in value. This is also called a “long position.”
- On this scheme, you aim to buy the security at a low price and sell it at a higher one.
- Buy low, sell high, duh! When would you ever do otherwise? When you take a short position.
means that you are invested in such a way that you will make money if the underlying security decreases in value. This is also called a “short position.”
- If you are doing this with stocks, you aim to sell high (first) then buy low.
- I know it sounds weird. What you do is sell someone else’s position (you broker borrows the stock for you) at a high price, and then buy back at a lower price (when the stock falls, for example) to return the borrowed security. You then keep the difference.
- Say you sell 100 shares of someone else’s stock at $100 a share (your broker gets that stock), and two weeks later it’s at $80 a share. You then buy 100 shares of the stock back at $80 a share, and return them to the owner. So the original amount was worth $10,000, but the returned amount was worth only $8,000 and you get to keep the $2,000 difference.
- That’s how to make money buying high and selling low.
These are ETPs that make money when the underlying index decreases in value – so it’s going short, but by using ETPs.
- Say you buy an inverse ETP for the S&P 500 because you think that the market is going to crash. If you’re right, then you’ll make money as the market declines.
Funds and Fund Managers
A fund is any set of securities run by aggregating many people’s money. They could be an ETP, a mutual fund, or a hedge fund.
- People distinguish between active funds, where the manager actively picks securities, and passive funds, like ETPs.
- Hedge funds are just funds that don’t have the governmental restrictions other funds have because all their clients are qualified investors, meaning (roughly) that their investors have so much money that the government has deemed it just fine for them to invest speculatively. The advantage for them is that hedge fund managers promise can make better returns.
- But why are they called “hedge” funds?
When you buy both sides (long and short) of a security—though this is hardly ever done in equal proportion. If you bought equal amounts both directions, then you’d not make any money on your investments, and you would lose the transaction fees to your broker.
- Traditionally, hedge funds were funds that invested with hedges, but that’s not true anymore. Now “hedge fund” refers to any fund that doesn’t have to abide by the restrictions pertaining to mutual funds.
Say you are a fund manager, and your aim is to give your clients the returns of the S&P 500, but without the downside that comes with recessions. How would you do this?
- You might do this by having your portfolio invested 98% in an S&P 500 ETF, but for the remaining amount short some of the companies that do very poorly in a downturn (they’re not too hard to find—Royal Caribbean Cruise, for example, does terribly in a recession because no one has any money to go on cruises).
- That way, if the market crashes, those short positions will make money—offsetting your losses.
- This is best done with leveraged shorts (see below) by using puts. That way, with a very small investment, the decline produces large returns, covering a much larger chunk of your portfolio.
Note: Unless you have access to a Bloomberg Terminal, you can’t find the information to all this stuff in the same place. So you’ll have to use a combination of (1) your broker’s account data, (2) Yahoo Finance, (3) Bar Chart (for when Yahoo is on the fritz), (4) the Bloomberg website, (5) the Security Exchange Commission’s website (Sec.gov), and for cryptocurrencies, I use Coinmarketcap.com and cryptocompare.com (free email registration for full chart functionality).Subscribe
3 The World of Cryptocurrencies
This is a fast-growing area, so you can find even more terms and notions with this post.
More Financial Terms for Investing
This is just your ordinary government-issued money or currency.
- The US dollar is an example, so is the British Pound, the EU Euro, and the Chinese Yuan.
- Incidentally, those are the four reserve fiat currencies of the world, giving them a special status.
- The US dollar, however, is the only currency indexed to the price of oil, and this is at least one reason why the dollar enjoys a place of privilege even among the basket of reserve currencies.
The first non-government issued (non-fiat) currency.
- Rather than place trust in the coercive power of traditional government, cryptocurrencies are backed up by blockchain technology.
- This technology runs (mostly) by hashes, which are just functions that aren’t solvable except by brute force algorithms.
- The result is that cryptocurrencies aren’t back by governmental power, but by math.
This is just a different way of serial (one after another) computing.
- There are a lot of explanations out there, but the idea is that one computational problem is solved after another.
- When one is done, it is linked to the previous one to form a chain of computation.
- In the case of Bitcoin, the result is a chain of transactions.
The idea behind Ether inverts the idea of Bitcoin.
- Bitcoin uses the ledger of transactions (the chain) to run Bitcoin as a currency.
- The Ethereum Network uses Ether to power the blockchain technology (I’ve simplified by excluding the role of Ether gas).
- The result is that the Ethereum Network is more like a global computing blockchain machine, and so it can run anything. It can even simulate Bitcoin’s price movement.
- Bitcoin, by contrast, is like a computer that only runs one program.
Coins, Platforms and Tokens
- While Bitcoin is more like a currency, The Ethereum Network is a platform – it runs other programs.
- Ether, which powers that network, isn’t really a coin then, and that’s why I call them platforms.
- Finally, there are tokens. These are coins that run specific applications.
- You can still buy and sell tokens just like coins – I’m only pointing out that not all cryptocurrencies are coins.
Third Generation Coins
While Bitcoin was the first generation of blockchain coins, Ethereum (and NEO) have emerged as a second-generation of ideas. They’re not even really coins.
- A third generation of coins, including Stellar and EOS, have emerged that present material improvements over the ideas of Ethereum NEO.
- The point about this is that unlike money, cryptocurrencies face a distinctive downside: obsolescence by technological innovation.
- This makes a really good case for trading cryptocurrencies rather than investing in them for the long haul.
Wallets: Hot and Hard
Like real money, you need to store your cryptocurrencies somewhere. These virtual places are called “wallets.”
- A hot wallet is one that is connected to the internet from your computer or mobile device. The drawback is that it can get hacked more easily there.
- A hard wallet (like Trezor) is a physical device that can be disconnected from the internet after use. As a result, it’s nearly impossible to hack. The downside is that it’s going to be a pain to use.
- You should keep large sums on a hard wallet if possible & remember that exchanges get hacked all the time.
Cryptocurrency exchanges are just like stock exchanges, but they trade cryptocurrencies.
Some are much better than others, and some have significantly different regulations. For example, if you live in New York, you can use Gemini but not Bittrex.
Bittrex is pretty good for coin-to-coin exchanges, but the world’s leading such exchange is Binance. You’ll need to turn your fiat currency into a cryptocurrency on another exchange.
I use Gemini as my fiat to coin exchange … again, mostly because I live in New York.
Initial Coin Offerings (ICOs)
When a stock is first brought into the public market, it has an initial public offering. In a similar way, when coins are first brought public, there is an initial coin offering.
When an IPO happens, the initial owners of a company make (usually) 15x on the value of their company. But that’s because they’re selling shares of their company’s stock. How do coin creators make money?
Usually, the creators of the coin hold back a percentage of the coins for themselves.
- So they might release 10,000,000 into existence, and keep 20,000,000 for themselves.
- For every dollar the market pushes up the value of the coin, then, their net worth goes up two.
- That is how coin founders became crypto-billionaires nearly overnight.
4 Multiplying Returns
This is when you buy a financial item in such a way that the results produce a multiple, say 3x, of the underlying security. This is often done by means of buying on margin or using options.
There are ETPs that aim to return 2x or 3x the results of the underlying index. NUGT, for example, is a 3x Bull (i.e. long) ETN on gold. If gold goes up 1%, NUGT is designed to go up 3%. There are both long leveraged ETPs and inverse (short) leveraged ETPs. The YINN is a 3x long ETP on the Shanghai Composite index (which is sort of the S&P 500 of China), and the YANG is the 3x inverse ETP on the same index.
Average Daily Balancing
Leveraged ETPs rebalance daily. This means that they have weird returns. If the underlying index goes down 5% then up 5%, you would be close to even on a regular ETP. But on a leveraged ETP, you’d be negative by more than 2%.
Day 1: (Regular) 100 – 5% = 95 v (Leveraged) 100 – (5%x3) = 85
Day 2: (Regular) 95 + 5% = 99.75 v. (Leveraged) 85 + (5%x3) = 97.75
Of course, the same holds for the flip side (had you gone up first, then down by an equal percent you’d be about 3% higher than when you began). The result is that leveraged ETPs should only ever be used short term, when you have a clear idea what’s going to happen, because the long term effects are quite unpredictable.
This is when you use your broker’s money to buy or sell securities. You can do this from 2x to 5x of your principle, depending on your arrangement with your broker.
- Yes, you are investing with other people’s money, so of course you don’t want to lose it.
- Yes, brokers have (sometimes steep) fees for buying stuff with their money, so these will need to be taken into account when calculating your pay-off.
A TRADITIONAL — USE OF MARGIN
Often people do this with bonds. Say that you have $1.2m for retirement, and would like a steady income. You could buy safe bonds that yield 4% annually, and do so on margin, say at 3x leverage. That would give you a 12% annual yield, or $144,000 annually to live on.
… Of course, you need to know what your broker’s fees are, and subtract that out. If they’re too high (like 13% annually), then this strategy is a no-go.
is a right to buy or sell a security as a specific price by a certain date. These can be either of the “long” variety or the “short” variety.
A Call Option
is a right to buy a security at a specific price by a specific date. If you buy these, you make money when the underlying security goes up in price, provided the security surpasses the strike price. If you sell these (to someone who buys them), the reverse is true.
Example: You buy a call option on ISUX, which is currently trading at $7.11 with a strike price at $8.00 and an expiration date of Jan 20, 2029.
- This means that if the stock goes up $.89 by Jan 20, 2029 you’ll hit the strike price, and you could exercise the option then – buying stock at $7.11 and selling it at $8.00.
- Suppose you bought this option for $.51, then your return would be .51/.89 = 57.3%.
A Put Option
is the opposite of a call option, since it is a right to sell a security at a specific price by a specific date. If you buy these, you make money when the security goes down in price, provided the security surpasses the strike price. If you sell these (to someone who buys them), the reverse is true.
is an obligation to buy a specified commodity (say oil) at a set price, in the future. If the commodity is worth more than the contracted obligation at that point, you can turn around and sell it immediately for a profit. Otherwise, you better hold onto it and hope the price goes up to recover your money later (that’s why people were storing millions of barrels of oil after oil prices declined).
is either an option or a contract to buy a specific security or commodity at a set price by a certain date. Examples include put and call options.
In/Out of the Money
When an option is below its strike price, it’s out of the money. When it’s above its strike price, it’s in the money – or in the black.
The easiest way to think of the VIX is as an index of volatility on the S&P 500. There is a mathematical formula to calculate the balance of futures on the S&P and it gives you the VIX.
- If the VIX is at 20, then divide that by the square root of 12 to give you the implied volatility of the S&P over the next month.
- In this case 20 / square root of 12 = 5.77
- So that means that any move within 5.77% up or down over the next month would be considered an expected movement.
These are the initial public offering of a stock. The reason founders become billionaires from these is that they are taking a privately held company public.
- Normally, a privately held company would only make a small multiple over its seller’s discretionary equity—which you can think of as net income.
- When it goes public, a 15x multiple over annual net income is average.
- So a founder can go from a company that nets $100m a year, to a 70% stock sale of that = .7 * $1.5B = $1.05 billion.
So the private equity investing “game” often consists in buying smaller companies with low multiples and then flipping them to public offerings. For example:
- ISUX is a company with $100m in annualized earnings and has a growing app market.
- A PE (private equity) firm buys them at 6x that = $600,000,000 and the original founder is happy at that sum.
- The PE firm them grows the company a little and prepares the paperwork for a public offering. It now makes $150,000,000 annually and they’ll flip it as a hot stock for 22x its earnings = 22 x $150m .7 (because they retain 30% of shares) = $2.31 billion.
- Minus their cost ($660M) = $1.65B
- And the desire for those returns is what made for pump-and-dump schemes like WeWork.
Notes & Disclosures
General financial disclaimer: I am not providing advice on financial investments and I am not a financial advisor. I am only explaining how I think about this process and imply no outcome or return on services. Please do your own due diligence before investing in anything.
Links may have referral ids: If they do, and you click on them, and you decide to buy something, the newsletter will receive a small commission that will not affect the cost to you.
Specific disclaimer: At the time of writing, I own a variety of cryptocurrencies, including Bitcoin and Ethereum. I might also own some of the stocks and ETFs discussed in these essays, including the SPY, QQQ, and CGC. In general, I trade these, so by the time you read this, I may not still own them.