About the Stock Market – Terms that Confuse
The stock market, like every other specialized area, has it’s own language. Some of the stock market terms can be confusing – even to highly educated people who have been investing for years. If you don’t think so, just tune into Power Lunch on CNBC and really listen.
Although I’ve been in the market since 1996, some terms still confuse me. These are often ones I don’t use much, but some are fairly common!
Here are some of the terms that confuse. Some of them, I just never can remember which one is which (like Bear and Bull – to me they are both just animals). Others are (in my mind) very esoteric and somewhat hard to understand – or are slight twists on other terms, with a tiny difference in meaning.
Bear with me while we muddle through these together. Some day we will explore using them!
Bears and Bulls.
A bull market is a rising market. A bear market is a declining one. The terms have been around for quite some time and refer to the nature of the animals. Bears attack by rearing up on their hind legs and swiping down. Some say that bears are somewhat sluggish. Bulls attack by putting their head down and swinging their horns up. Some say that bulls are more spirited.
What is confusing? Probably nothing, but for some reason, I always have to stop and think about which is which!
Wall street players are continually inventing new types and combinations of investments. Exchange Traded Funds (ETFs) are one of these inventions. The first ones surfaced around 1993, but didn’t become widely used until the 2000’s.
A SPDR (spider) is an example of an ETF. SPDR stands for Standard and Poor’s Depository Receipt and is an exchange traded fund that holds American Depository Receipts (ADR). To allow Americans to invest in the foreign stock markets, banks hold the stock certificates and issue deposit receipts to investors wanting the securities.
An exchange traded fund is a fund that holds assets in stocks, bonds, commodities and etc. The fund trades during the day on the open market – it’s fund price rising and falling with demand that day.
Differences between ETFs, mutual funds and closed end funds.
ETFs are similar to mutual funds in that they are composed of stocks, bonds, etc, however, they are governed by different Securities and Exchange Commission (SEC) rules that allow them to trade like a stock, instead of selling at the same price (yesterday’s closing net asset value) all day.
A closed end fund is a fund that is composed of underlying stocks, bonds and etc as well. However, there are a set number of closed end fund shares that can be bought (determined when the fund is started). There is also a set date when the fund will be liquidated and money returned to the investors. You can’t get your money out by redeeming fund shares (as you can in a mutual fund). In order to get your money out before the fund liquidation date, you sell them on the market to other investors that want those shares – hence the price rises and falls with demand. These too have their very own SEC rules
You want to buy corn now, before it has grown and been harvested, because you think it will be scarce and higher priced in late summer. The farmer down the road wants to sell corn now, because he knows that all of his farmer friends across the mid-west are also planting corn and he thinks it will be too plentiful – driving the price down in late summer. So the two of you draw up a contract, which formally obligates you to buy the corn (and maybe accept delivery of a ton or so in late summer) at a certain price and the farmer to sell the corn only to you for that price in late summer. (Note that this is a simplistic view of futures!).
You as the buyer, are ‘long’ in the contract – you think the price will go up in the long term. The farmer as the seller is ‘short’ in the contract – he thinks the price will go down in the long term.
A futures contract is a standardized agreement between two parties but it is mediated by a futures exchange institution (such as the Chicago Mercantile Exchange). This institution requires the parties to put up a margin (a certain amount of money or assets). The standardization and use of the exchange institution allow the contract itself to be very easy to sell.
Between now and late summer, other people are also betting on the price of corn in late summer. Every day, standardized contracts are drawn up at a different ‘future’ price. The futures exchange figures out the difference between the price you agreed to pay and the future price on the market today and gives or takes money from your margin account to bring your price up to or down to the current ‘futures’ price. This is called marking to market. It means that the price in your contract is really not the price you pay on the expiration date.
The product you take a futures contract on does not have to be corn or any other commodity. It can be a financial asset or even a short term interest rate.
Long and Short.
Being ‘long’ or in a ‘long position’ means that you expect the price of the asset in question to rise. If you own a stock, you are ‘long’ in that stock.
If you purchase an option (see below) to buy a certain stock in the future for a price you set now, you think that the price will rise in the future.
Being ‘short’ or in a ‘short position’ means that you expect the price of the asset in question to fall. You won’t be owning the stock – you will be trying to dump it before the price falls.
If you purchase an option to sell a certain stock in the future for a price you set now, you think that the price will fall in the future.
Lets say you own Disney stock and want to sell some of it. However, you don’t want to take just whatever the market is buying Disney for today – you want to get at least a certain price. To do that you enter a ‘limit order’ which limits the price at which your stock can be sold.
For instance, say Disney is selling today for 44.95 but you want to sell for 46.00 a share. You can call up your broker and say I want to sell xxx shares of Disney with a limit order at $46.00 a share. You then tell the broker how long you want the order to be in effect. Good until cancel lengths usually last about 60 days. If the price goes up to $46.00 a share anytime within the next 60 days, your stock is sold.
You can buy a contract that gives you the right to purchase a security or other asset in the future at a specific price. This is called an option.
Let’s say that you think Coke shares will go up due to inflation. Lets say it is selling for $61.28 a share today. You think it will be selling at 70 in 2 months. You can buy a contract that gives you the right to buy Coke shares at $62.00 in 2 months (when it is hopefully selling for $70 a share). In 2 months, you ‘exercise’ your option – buy the shares for $62 and then sell them right away for $70 – making $8.00 a share less the cost of the option contract, fees, taxes and commissions.
You have a ‘call’ option (because you will call the shares in when it comes time). You are ‘long’ in the option (because you think the price will go up in the long term). You are called the ‘holder’ of the option (because, hey, you are holding it!)
You can also buy a contract giving you the right to sell a security or other asset in the future at a specific price. This is also called an option.
Lets say that you think Coke shares will go down due to competition with Pepsi. Coke is selling for $61.28 a share today. You think the shares will be selling for $50.00 a share in 2 months. You buy an option to sell Coke at $59.00 a share for the next 2 months. The price drops to $50.00 a share. You buy in the open market at $50.00 a share and then exercise your option to sell at $59.00 a share – making $9.00 a share less the cost of the contract, fees, taxes and commissions.
You have a ‘put’ option (because you will have to put the shares into the buyers hands if the option is exercised). You are ‘short’ in the option (because you think the price will go down in the long term). You are also called the ‘holder’ of the option (because, hey, you do hold it).
If this options business sounds confusingly similar to a futures contract – you aren’t alone! The difference, as I understand it, is that the owner of the options contract is not obligated to execute the option, but the futures contract owner is obligated to do what the contract says.
These are some of the stock market terms I find confusing. Hopefully I haven’t confused anyone further. Just wait until another post – when I try to explain VIX to myself and to you!
All of you investor gurus, if I have anything not clearly stated, please please comment!