Glossary of Key Terms
Algorithm A set of rules for accomplishing a task in a certain number of steps. One common example is a recipe, which is an algorithm for preparing a meal. Algorithms are essential for computers to process information. As such, they have become central to our daily lives, whether ordering a book online, making an airline reservation or using a search engine. (See System)
Asset Allocation A portfolio strategy that involves setting target allocations for various asset classes, and periodically rebalancing the portfolio back to the original allocations when they deviate significantly from the initial settings due to differing returns from various assets. The target allocations depend on a number of factors – such as the investor’s risk tolerance, time horizon and investment objectives – and may change over time as these parameters change.
Average True Range (ATR) The average over the last “X” days of the true price range, which is the largest of the following: (1) today’s high minus today’s low; (2) today’s high minus yesterday’s close; or (3) today’s low minus yesterday’s close. ATR is a measure of volatility and a useful tool in managing risk and establishing position size.
Bet Size The initial acceptable dollar risk taken in a given position. It is defined by one’s initial downside price alert.
Biases Are human tendencies that lead us to follow a particular quasi-logical path, or form a certain perspective based on predetermined mental notions and beliefs. When investors act on a bias, they do not explore the full issue and can be ignorant to evidence that contradicts their initial opinions. Avoiding cognitive biases allows investors to reach impartial decision based solely on available data
Commodities A commodity is a basic good used in commerce that is interchangeable with other commodities of the same type. Commodities are most often used as inputs in the production of other goods or services. The quality of a given commodity may differ slightly, but it is essentially uniform across producers. When they are traded on an exchange, commodities must also meet specified minimum standards, also known as a basis grade. Any good exchanged during commerce, which includes goods traded on a commodity exchange. The basic idea is that there is little differentiation between a commodity coming from one producer and the same commodity from another producer - a barrel of oil is basically the same product, regardless of the producer. Compare this to, say, electronics, where the quality and features of a given product will be completely different depending on the producer. Some traditional examples of commodities include grains, gold, beef, oil and natural gas. More recently, the definition has expanded to include financial products such as foreign currencies and indexes. Technological advances have also led to new types of commodities being exchanged in the marketplace: for example, cell phone minutes and bandwidth. The sale and purchase of commodities is usually carried out through futures contracts on exchanges that standardize the quantity and minimum quality of the commodity being traded. For example, the Chicago Board of Trade stipulates that one wheat contract is for 5,000 bushels and also states what grades of wheat (e.g. No. 2 Northern Spring) can be used to satisfy the contract.
Consolidation A pause in the market in which prices move in a limited range.
Discretionary Trading A decision based upon the instincts of the trader as opposed to a systematic approach.
Diversification A technique that addresses risk by allocating investments among various financial instruments, industries and other categories.
Drawdown A decrease in the value of an account because of “paper losses.” This may occur simply because of a decline in the value of open positions.
Equity The value of your account.
Equities Refers to stocks secured by ownership in the company.
Filter An indicator which selects only data which meet specific criteria. E.g. stocks closing at one year high and below $30 per share. Too many filters tend to lead to over optimization.
Fractional Bet Sizing The percentage of account value one chooses as an acceptable risk (assumed loss) per position. It is used to calculate the size of a position one takes. E.g. an accepted risk of ½% on a $500,000 account is $2,500. A $10.00 stock with a price alert of $9.00 would allow for the purchase of 2,500 shares as a loss taken at that price would be $2,500.
Frequency The total number of observations or trials within a given range. For example, a “trading system” in which 7 out of 10 trades is profitable has a frequency of 70%. A high % frequency of positive trades is profitable only if they cumulatively off-set the magnitude of the 30% negative trades. (See magnitude)
Fundamental Analysis A method of evaluating a security that entails attempting to measure its intrinsic value by examining related economic, financial and other qualitative Security analysts are hired to use this data to potentially predict future prices.
Gambler’s Fallacy The belief that a loss is due after a string of consecutive gains or a gain is due after a string of consecutive losses.
Game A game is a competitive activity involving skill, chance, or endurance on the part of two or more persons. Key components of games are goals, rules, challenge, and interaction. Games, dating back as early as 2600 BC, are universal parts of human experience and present in all culture.
Holy Grail System A mythical trading system that perfectly follows the market and is always right, producing large gains and zero drawdowns. No such system is known to exist.
Index An index is a statistical measure of change in an economy or a securities market. In the case of financial markets, an index is an imaginary portfolio of securities representing a particular market or a portion of it. Each index has its own calculation methodology and is usually expressed in terms of a change from a base value. Thus, the percentage change is more important than the actual numeric value. All indices are unmanaged and may not be invested into directly.
Largest Expected Equity Drop Refers to the largest drop in equity that you will tolerate. It is used in limiting risk.
Long Owning a marketable item in anticipation of a future price increase. (See short)
Magnitude The size, extent, or importance of something. A “trading system” with 4 of 10 winning trades can be a very profitable if the 4 winning trades are sizable enough to off-set the 6 losing trades. Babe Ruth was famous for his homerun hits (magnitude) vs his more frequent strikeouts. (See frequency)
Modeling The process of determining how some form of peak performance is accomplished and then passing on that training to others. (“I can, because others have”)
Momentum This refers to an indicator which represents the change in price now from some fixed time period in the past. Momentum is one of the few leading indicators.
Negative Expectancy System A system in which you will never make money over the long-term. E.g. all casino games are designed to be negative expectancy games for the players.
Nominal Rate of Return Is the amount of money generated by an investment before expenses such as taxes and inflation are factored in.
Position Sizing Determines how large a position you will put on throughout the course of a trade. In most case, algorithms for determining position size are based upon one’s current equity. * (See Fractional Bet Sizing)
Positive Expectancy Describes a system (or game) that will make money over the long term if played at a low-enough risk level. All casino games are designed to be positive expectancy games for the casino.
Prediction The act of stating what will happen in the future. Most people want to make money through the process of prediction. Security analysts are employed to predict future prices.
Price In a freely traded market, an item’s current price reflects all that is known at that moment. The core of a Trend-following system is using algorithms, based on price movement, to enter or exit a market. No attempt is made to “predict” market movement or direction. The price change itself signals the action to be taken. This process diverges from traditional fundamental analysis which attempts to be predictive. (See Fundamental Analysis)
Price Alert A pre-determined price, which if reached or exceeded at the market’s close, will initiate a buy or sell decision on the next day’s market. Price alerts are dynamic in that they are adjusted upward as prices advance. They are never moved downward except to adjust for a corporate event such as a cash or stock dividend, stock split etc.
Reliability Refers to how accurate something is or how often it wins. Thus, 60% reliability means that something wins 60% of the time.
Retracement A price movement in the opposite direction of the previous trend. Retracement is usually a price correction. The movement of ocean waves during an incoming or outgoing tide is descriptive of retracement.
Risk The chance that an investment's actual return will be different than expected. Risk includes the possibility of losing some or all of the original investment.
Set-Up This term refers to part of a process in which certain criteria must be present before one looks for an entry into the market.
Short Selling The act of selling a marketable in order to be able to buy it later at a lower price. When you sell before you have bought the item, you are said to be “shorting” the market.* (See Long)
S&P 500 The Standard & Poor's 500 is one of the world's best known indexes, and is the most commonly used benchmark for the stock market. Other prominent indexes include The Wilshire 5000 Total Market Index, which consists of more than 5000 companies, represents virtually all of the capitalization of the entire U.S. stock market.
The MSCI EAFE Index is a free float-adjusted market capitalization index that is designed to measure the equity market performance of developed markets, excluding the US & Canada. The MSCI EAFE Index consists of the following developed country indices: Australia, Austria, Belgium, Denmark, Finland, France, Germany, Hong Kong, Ireland, Israel, Italy, Japan, the Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland and the UK.
The Barclays U.S. Aggregate Bond Index is an index of the U.S. investment-grade fixed-rate bond market, including both government and corporate bonds. All indices are unmanaged and may not be invested into directly. (See Index)
System A system is a set of rules for entering and exiting the market. A complete system will include an entry signal, a position sizing algorithm, a price alert for taking a profit or to minimize a loss and portfolio level risk parameters. (See algorithm)
Trading Establishing a position in the market, either long or short, with the expectation of either closing it out at a substantial profit or cutting losses short if the trade does not work out.
Trend-Following The systematic process of seeking profit by capturing large price trends, up or down, the market and staying in the market as long as the “trend” continues.
Volatility A term that refers to the range of prices in a given time period. A high volatility market has a large range in daily prices, whereas a low-volatility market has a small range of daily prices.