HomeBlogCommon investing terms every trader needs to know

From yield and arbitrage to rally and moving average, at times it may feel like investment comes with a language of its own. Each related to strategies, patterns, charts, indixes and a score of other elements related to the industry, getting to grips with this terminology is important since not only will it allow you to accelerate your learning process if you’re new to investing, but by being more knowledgeable, you’ll better understand how and where your money is being invested.

Here we decode some of the most common investment terms so that you can sharpen your knowledge and trade with confidence.

Yield

This refers to the measure of return on an investment that is received from the payment of a dividend, coupon or net income over a particular period of time. The yield is expressed as a percentage and it is based on the investment amount, as well as the current market value or face value of the security. For instance, the average yield of stocks on the S&P 500 typically ranges between 2% and 4%. It is mainly calculated on an annual basis, yet at times the quarterly and monthly yields are also computed. What’s more, yields can vary depending on the security, the duration of the investment, as well as the return amount.

While investors tend to focus on dividend payments, it is important to keep tabs on yields. Yield focused companies that operate in low growth but have resilient cash flow from operations tend to fall under the safer end of the equity spectrum. The direction of travel in the dividend yield is also a key indicator of company performance. It may be rising due to two opposing factors – firstly, the company’s earnings are increasing and management is confident on future cash flows which will lead to a higher dividend payment and secondly the company is underperforming and as a result its stock price is falling which may be a reflection of a potential reduction in future dividend payments. Higher stock prices for dividend paying companies may show optimism that dividend growth is sustainable.

A simple example:

The formula used to calculate yield is the following – Yield = Net Realised Return / Principal Amount. If we assume that an investor invests in a company’s shares which has a current share price of $231.69 and a quarterly dividend of $0.80 per share (ie. $3.20 dividend per share annually) then the current dividend yield is 1.38%.

Arbitrage

Arbitrage is when a security or commodity trades on two different markets at different price points. When this occurs, investors can create a profit by benefiting from the temporary price differences in each venue. As a result, investors with a constant eye on the markets can buy low in one market and sell high in another, however, with advancements in technology, profiting from pricing errors in the market has become increasingly difficult. Arbitrage is caused by market inefficiencies and it is considered useful to markets since it provides liquidity for trading.

A simple example:

The stock of a particular company is trading at $20 on the New York Stock Exchange (NYSE), but at the same time, it is also trading for $20.05 on the London Stock Exchange (LSE). If an investor buys a stock on the NYSE and sells the same shares on the LSE, they earn a profit of 5 cents per share, making good use of this arbitrage.

Short selling

An investment or trading strategy, short selling takes place when an investor borrows a security and sells it on the open market, but plans to buy it back at a later stage when its price would have dropped. In other words, short sellers bet on and profit from a drop in a security’s price. The rebought stock is returned to the lender and the difference between the sell price and the buy price is the short seller’s actual profit.

There are two primary reasons why an investor may want to short sell. The most obvious reason is to profit from an overpriced stock or market; however, some investors use short selling to hedge, in other words, protect other long positions by offsetting short positions.

Short selling has a high risk versus reward ratio, which means that it can offer big profits, yet losses can rise just as much and although it may sound like a simple strategy, this is an advanced tactic that should only be undertaken by experienced investors. In short selling the maximum gain is 100% if the price goes to zero, however, the losses can be unlimited as the price can continue to increase.

Fun fact:

Perhaps one of the most popular examples of a successful short sell was back in 1992 when George Soros famously brought the Bank of England to its knees. For those unfamiliar with the so-called trade of the century, Soros risked $10 billion that the British pound would fall. He was right and the following night he made $1 billion from the trade. His profit eventually reached almost $2 billion.

Day trading

Day trading typically refers to the practice of purchasing and selling securities within a single trading day and although it can take place in any marketplace, it most commonly occurs in the foreign exchange (forex) and the stock markets. As opposed to traditional investing techniques that involve buying low, holding the securities for a period of time and then selling high, day trading is a short-term strategy that aims to profit from small, intraday fluctuations in price. By not holding any securities overnight, a trader can avoid unmanageable risks and negative price gaps between one day’s close and the next day’s price at the open. Some of the most commonly day traded instruments include stocks, options, futures contracts like stock market index futures, interest rate futures and others, as well as currency including cryptocurrency.

Mainly focusing on an asset’s price action as opposed to its long-term potential, day traders need to remain up to date with breaking news that might cause market fluctuations, while they tend to use trading strategies that involve technical analysis. Some of these include scalping which attempts to make small profits on small price changes throughout the day, news-based trading which seizes trading opportunities from heightened volatility that could have arisen due to news events or range trading which primarily uses support and resistance levels to determine when to sell and buy.

Some background info:

Once an activity carried out exclusively by financial firms and professional speculators, today there are several individuals who work as specialists in equity investment and investment management. Day trading became popular following the deregulation of commission in the US in 1975, the advent of electronic trading platforms in the 1990s and following the stock price volatility during the dot-com bubble.

Rally

A rapid increase in the general price level of the market or of the price of an individual stock, bond or index, a rally can take place in both a bull and a bear market, yet it will typically follow a period of flat or declining prices. The word itself is often used as a buzzword by media outlets. The length or magnitude of a rally will depend on the number of buyers, as well as the amount of selling pressure these face. Short-term rallies are caused by events that can affect the demand-supply equilibrium. On the other hand, long-term rallies can result from changes in macroeconomic factors like changes in key interest rates.

Bonus tip:

Wondering what to do during a market rally? Establish a strategy on which asset classes to invest in. For instance, if the prices of small and mid-cap assets increase and bets become risky, you may want to consider allocating some of your money towards large-cap equity funds since these may be able to maintain portfolio returns during a market rally. Having said that, it’s important to remember that it is very difficult to predict the direction of the markets. With this in mind, make sure your portfolio is as diversified as possible so you can manage any risks better.

Blue-chip stocks

What do industry heavyweights like Boeing Co., Amazon Inc., Coca-Cola Co. and the likes have in common? Without a doubt, they are household brand names recognised across the globe and lauded for their quality services and products. As financially sound companies, their stocks are known for their stability and in effect, these blue-chip stocks tend to have market capitalisations in the billions. In addition, they form part of the most reputable market indexes or averages like the Standard & Poor’s 500 (S&P 500) in the US, the FTSE Index in the UK or the TSX-60 in Canada and others.

Among the most popular types of stocks investors typically buy, what makes these so appealing is that they may also offer stable dividend payments. For instance, Verizon Communications (VE) is currently trading under $60 and is yielding a solid 4.38% dividend.

Interested in blue-chip stocks? How about investing in these industry heavyweights like Tesla (TSLA), AstraZeneca (AZN), Snowflake (SNOW), Alibaba Group (BABA) or one of the FAANG stocks (a.k.a. Facebook (FB), Amazon (AMZN), Apple (AAPL), Netflix (NFLX), Alphabet (GOOG)?

Fun fact:

Wondering how these stocks got their name? The expression is thought to have derived from the blue gambling chips used for playing poker, whereby the blue chips are the most expensive ones.

Haircut

A haircut is known to have two meanings. One refers to the difference between an asset’s current market value and the value ascribed to it so as to calculate regulatory capital or loan collateral. One reason why there is a difference between these values is because market prices change over time and as a result, the lender needs to accommodate for this. It goes without saying that the larger the risk or volatility of the asset price, the larger the haircut. The haircut is expressed as a percentage and when assets are used as collateral for a loan, these are generally devalued since a cushion is required in case the market value falls.

For instance, treasury bills are relatively safe and highly liquid assets, which means that they have little to no haircut. On the other hand, a more volatile asset might have a haircut as high as 50%.

A simple example:

If an individual would have taken a €10,000 loan and would have like to use their €10,000 stock portfolio as collateral, their portfolio would only be considered as €5,000 in collateral by the bank. This 50% reduction in the asset’s value for collateral purposes is known as the haircut.

The haircut’s second meaning refers to an extremely thin spread between the bid and ask prices of a given stock. Market makers, in other words, dealers in securities or other assets who undertake to buy or sell at specified prices at all times, can transact with razor-thin spreads and low transaction costs so they can take small haircuts of profits or losses constantly throughout the day.

Although not exhaustive, this list can help you sharpen your investing knowledge and brush up on important terms if you are already familiar with them. And here are some tips for successful trading.

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CCTrader is brought to you by Calamatta Cuschieri Investment Services Ltd and is licensed to conduct investment services business by the MFSA under the Investment Services Act.

CCTrader offers direct market access and speed of execution and is intended for knowledgeable and experienced individuals taking their own investment decisions. The value of investments may go up and down and currency fluctuations may also affect investment performance.

The contents of this article are not intended to be taken as a personal recommendation to invest but strictly based on research and for information purposes only. Retail investors should contact their financial adviser for a suitability assessment prior to taking any investment decisions.

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