StockWave Financial Glossary E

Glossary E

The financial world is full of jargon - i.e. strange words no-one understands. Here we try to explain some of the many technical terms.

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E

Economics

Also known as The Dismal Science, which is rather a misnomer, since while being dismal, it is certainly not science; as an academic discipline it provides a useful dumping ground for third and fourth-raters who cannot hack it in real science, like physics, or in pure mathematics.

The danger with economics is the largely undeserved respect it carries within certain sectors of the community - politicians actually listen to these guys, so they have clout; which means whenever some economist comes up with some barmy theory which a politician likes, you are likely to get it thrust upon you. What would otherwise be seen as crude top-down class warfare or social engineering in the raw, are thus given spurious intellectual justification by the perceived gravitas of the professional economist.

Economics, in short, is really more of a religion than a science; it has its articles of faith, its dogma, its schools of indoctrination, its priesthood, zealots, evangelists and even its inquisition (- the IMF) - and just like all the other religions, it has a problem dealing with the real world, i.e. things as they actually are. The real world, it should be pointed out, always wins out in the battle for truth.

BTW - having an economics degree could seriously damage your chances of being a good trader - 4 years of brainwashing in 'how the world is meant to work' could irreparably prevent you from being able to 'see the world as it is'.

The Economist

A monthly journal, pseudo-academic in tone, regarded very widely as being fantastically authoritative, certainly in economic matters and even wider still.

If The Economist says it, then it must be true; its analysis is correct, and anyone who disagrees with it is likely to be biased, or simply too stupid and ignorant to understand the problem ... thus all challenges are dealt with.

But if you read The Economist for any length of time, you will find that there are invisible barriers to discourse outside of which nothing exists; implied assumptions are everywhere; what you really get is shallowness posing as insight and bombastic puff for the market ideology.

Economists

Pompous pseudo-scientists, creators of crude mathematical models based on imaginary concepts, with little relevance to the real world. Often wheeled out as political puppets to provide some 'rigorous' justification for whatever their masters are doing at the time.

You will not often be able to understand what an economist is on about, which is no great loss.

- 'How many angelic rational agents can balance on the head of a perfectly efficient pin, using a linearized economic model of Paradise.'

Economic Policy, Government

Given the instability of the markets and their basic unpredictability, you can imagine the problems government ministers and central bankers have, i.e. in trying to control the uncontrollable. In general, the aims of these men are to -

Protect the value of the currency, i.e. low inflation
Stabilise the market
Generate steady growth
Avoid deflation (- this is a new phenomenon.)
Support the value of equities

It is hardly a coincidence that these aims are precisely those which the very rich would be in favour of, given their large cash reserves and their stock market investments. What is possible with regard to social policy - health, education, housing, welfare - follows directly from the economic; no pay, no play (- and even when there is plenty 'pay', you might still get no 'play'). Political promises are thus for the most part, pretty flimsy, and depend on highly unpredictable monetary phenomena.

A good analogy for controlling the economy as a whole would be steering a supertanker in a massive hurricane; the supertanker has tremendous inertia - when it is going one way, it wants to keep going the same way; the hurricane is the enormous external pressures on the economy, i.e. the markets, and the steering controls of the ship - throttle and wheel, represent the setting of interest rates and other economic measures. Note that while steering controls exist and the pilot may be a good navigator, where he actually ends up, will be in the lap of the gods.

Emergent Phenomena

A phenomena which emerges from a sub-stratum of rules; i.e. something which does not exist in the system to begin with, but 'emerges' as the dynamics evolve. It is an order-from-chaos type of thing.

Emerging Markets

Playgrounds for the thrill-seeker.

Emotion

The arch-enemy of the trader; fear and greed destroy reason.

When trading there is a natural cycle at work; if, say, buying stock, then we start out with optimism, as the price rises, we feel happy; as it keeps rising, anxiety kicks in - it cannot rise forever surely? This anxiety then turns to fear as we face the prospect of losing our gains, but then greed also kicks in, as we think of how foolish we will feel if we get out too early. The fear and the greed cause angst and turmoil; actions become irrational.

Enron

Enron was an energy trader which collapsed in spectacular circumstances. Yet to be resolved in any detail, the main ingredients seem to be - an upper management loaded with stock options; close relationships with auditors, accountants and merchant banks; an extremely dynamic corporate culture driven by a charismatic leader and a massively elaborate corporate structure. Derivatives were also heavily involved.

EPIC

A three or four letter code, unique to each company; also called the ticker or simply the symbol.

Equation

A concise symbolic representation of a piece of knowledge. Truth laid bare.

Having an equation is a very comforting thing - now we know what is going on, all we have to do is solve it! But this may be rather more difficult than we imagine or may even be impossible; also, in physical or real-world situations we have to be aware that our equation may only be an approximation. i.e. a partial truth - this is why when dealing with the real world we can't simply rely on mathematical proof, but need experimental testing as well - our models often lack some essential aspect of the real world.

Having used StockWave for a little while, the user may begin to feel some nuisance creeping in - all this Monte Carlo simulation, it takes so long, why can't we just solve some equation instead, it can't be that difficult surely; my other software calculates three dozen technical studies per second ...?!

And we do take the point, but to help justify our approach we shall consider the alternative for the moment - we shall try to see what it would take to derive an equation for share price movements.

Consider the processes affecting share prices -

Share prices represent the expected worth of a company to those trading it; people buy when they think the value will go up and sell when they think it will go down. When there are more buyers than sellers the price goes up and vice versa. In judging the value of a share the trader looks at the chart, listens for affecting news events and perhaps also looks at financials, i.e. the 'fundamentals'; the trader is also learning at the same time - he will be aware of his past strategies, successes and failures and will be in continual adjustment to these.
When the trader looks at a chart he is mentally trying to predict in his head what will happen in the future; if he feels confident about where the price will go, he is more likely to trade, i.e. the perceived 'predictability' of the share price history is important. Human beings are good at predicting linear trends or simple periodic behaviour; this ability degrades in the presence of noise, i.e. volatility.
News events which occur can be roughly categorized as 'good' or 'bad'; good news makes traders buy and bad news sell.

So, our equation is basically, (in words to begin with) -

The next price will be the old price plus other terms; two random variables representing good and bad news, shoving the price up and down respectively; a predictability factor which accentuates the perceived trend, and lastly a term we shall call 'reality-check'.

Reality-check is a term which represents how far from its fundamentals the current share price is; it is a delayed reaction effect. When the price goes too far either way, there will be some kind of rebound. This makes obvious sense - we've all seen situations where there has been some relentless march upwards in value, but we know it cannot be sustained.

While this 'word equation' (- which is not mathematics, and can't be solved) seems to cover all aspects of the situation, it really only hides our ignorance - for already we are in trouble when we attempt to find proper mathematical representations of these terms.

News is a random variable, it is also 'bursty', i.e. news events happen in bunches then not at all for a long while. What is more, how we calibrate a piece of news is problematic. Note that we now have to do Monte Carlo simulations anyway.
The predictability could be represented by something which measured the past share price histories 'deviation from pure randomness' - but it is unclear precisely what this should be.
Reality check is a very difficult thing to model; we know that in many occasions it will be very small, and yet in others very, very large. Exactly what should be used as a measure of this 'deviation from reality' is tricky - perhaps the P/E Ratio, or some other combination - but what should the functional dependence of this be - remember that it is the perception of this by the market we have to model. Furthermore, the reality check would seem to be sensitive to the future deviation from reality, i.e. the deviation of the expected future price values. But the expected future price values are what we are trying to solve for in the first place! Oh shit! We need to solve the thing, before we can define it!
Fundamentals are, and have been, subject to gross manipulation; to account for this we can use a ranges of values for them in our model - but this involves sampling a potentially large parameter space, i.e. doing lots of runs.

Its all starting to look pretty slack-arsed ...

Give this specification to a friendly mathematician and in a few hours he will produce something very pretty for you to look at; pretty-to-solve-at is another matter, for what you will have is - a nonlinear, multivariate, stochastic, integro-differential equation, in an unknown number of variables, with unknown functional dependencies, unknown/poorly known/inaccurate parameter values. Equations of this nature actually occur in physics - in quantum theory they are known as Dyson-Schwinger equations; these are, for all ordinary, interesting situations, utterly intractable. Solutions do exist, but only for cases which have been simplified to extreme levels; perturbation schemes can be used, but these are limited and tedious. So if you want to get a real solution you get back to: Monte Carlo simulation.

But isn't having a 'master equation' of great interest - even if we cannot fully solve it?

Yes, if you are a physicist or mathematician and you want to make a name for yourself; we, on the other hand are trying to study the stock market in order to make money on it - we do not seek insight or truth into some underlying generative process, what we want are accurate probabilistic estimates about market moves. In this case having a cherished master equation may become a sore hindrance to us - self deception may occur as having it may make us feel we know more than we actually do. Approaching the stock market as a pure data analysis problem allows us to ditch any preconceived notions about how things are, or are meant to be - we only see what is, what we measure; our analyzers allow us to look at the problem in various ways, making for the most part, very few assumptions about what is going on - we look at the data, all of the data, but only the data; if we find some order within it, we shall attempt to exploit it. We do not take the data then selectively manipulate it until it supports some already-held viewpoint.

Equitable Life

Yet another pensions company that has cheated its policyholders.

The troubles at Equitable Life sent shockwaves through the UK pensions industry - many people lost out, even more are very worried indeed. The important point to note in this scandal is just how well-respected Equitable Life was; this wasn't some cowboy outfit, Equitable was thought to be the most solid company you could trust your money with, the argument then goes - "If you can't trust Equitable Life, who can you trust?!" (No-one, is the simple answer to that.)

The details of the problems at Equitable centre around their guaranteed annuity rates policies - when the stock market started to decline they found that they could not cover their exposure, so, by an accounting sleight-of-hand they attempted to renege on these guaranteed rates, but this was challenged in the courts; they lost, and so now face a huge liability which they cannot cover.

Equity Release

High interest rate loans aimed at elderly home-owners who are 'asset-rich' but 'cash-poor'; almost always very poor value.

If you want to turn equity into cash the simplest way is to move to a smaller property and pocket the difference. If you still want to take out a loan, then you could try re-mortgaging (- but what if interest rates start going back up again?)

Ethics

Some market advocates have suggested that ethics and social responsibility have no place in business - all that the directors must do is to maximise shareholder value; the inclusion of references to environmental and green issues within the company information module must therefore seem somewhat jarring to some - more relevant to some bearded eco-warriors anti-globalisation Web site than to trading and investing software, surely?!

We disagree with this, and not only from the moralistic viewpoint, but from the hard-nosed investing one as well. Think on this - all actions take place within a moral context, if that context is nothing but a vacuum, the investor must beware; if the CEO of a multinational will not hesitate to dump poisonous heavy metals in the drinking water of some 3rd world villagers, do you think he will draw the line at looting the company pension fund, or inflating the earnings in the company report?

Exceptional Items

In the ascertainment of business profits for a particular period it is customary to deduct from turnover the various expenses, both direct and indirect, incurred in achieving that turnover. Occasionally items of expenditure occur which are of an unusual nature or of a once-only variety and which, in the opinion of those preparing the accounts, could lead to a misleading net-profit figure when comparisons are made with similar periods in the past.

The fact that such irregular items have a habit of recurring in a fairly regular manner, in different guises, is frequently overlooked.

Ex-Dividend

If you buy a share that is ex-dividend then you are not entitled to the last dividend it declared.

Expert System

A computational reasoning system based upon rules and logic, i.e. knowledge is represented by statements built with combinations of IF, THEN and the logical connectives AND, OR, NOT.

The main problem with expert systems is that many problems cannot easily be mapped into the required structure, e.g. there are not sufficient rules, or the use of logic becomes too constricting. However, when available, they can be very appealing to users as one can see the reasoning which is being applied, and seems closest to the way in which human beings think in solving problems. Practical systems may require a large number of rules and the internal algorithms may also have to be tweaked to give good performance.

An expert system becomes more practically useful when we add-in fuzzy logic.

Expiry Dates, in Options Trading

Options have expiry dates, after which they become worthless - this applies to both American and European style options; in American options we can exercise early, whereas with European we can only exercise on the expiry date. The extra advantage of the American option is that it allows us, if we suddenly find ourselves heavily in profit, to 'take the money and run' so-to-speak.

The worth of an option is consists of two terms - the intrinsic value, i.e. the amount by which it is in-the-money and the time value which represents the chances of the option moving in-the-money during the time it has left - the time value is thus an estimate, the accuracy of which depends on the quality of your pricing model; so, even highly out-of-the-money options can be expensive if there is enough time to run.

Writing (- selling) options is used by many companies as a way to generate an income stream - you get a big pile of premiums which you can book nicely into the profit ledger. What is more, companies often issue options with very long expiry dates - this means that any possible exercise will take place beyond the current accounting horizons, deferring any possible losses incurred by them. Its free money!

But this is a dangerous thing to do; by now, having adopted the probabilistic mode of thinking, you should realise that, if you wait long enough, then anything, any outlandish, 'impossible' thing, will eventually happen (- US readers will no doubt accept this). Of course in dealing with this your pricing model should come into play - unfortunately, the deficiencies of any model will be more sorely exposed the further into the future we go; if you want to issue long-dated options, then your pricing model needs to be spot-on.

In our opinion, most pricing models underestimate risk at long times; there is substantial evidence to suggest that 'extreme events' are not as extreme as we would like to imagine. The consequence of this is that companies which have used derivatives to generate an income stream may have a far greater risk exposure than is thought - this means that apparently strong fundamentals are nothing but; such risk exposure is often dealt with inadequately by the company report.

Exponential Moving Average

A moving average which gives a heavier weight to recent data.

Moving averages, of varying types, are normally the first thing one sees when looking at charting software - StockWave doesn't have any, at all. This is because while they may look nice, moving averages don't really tell you anything. Nil. Zilch. Nada.

Extraordinary Items

Similar to exceptional items, the precise difference being somewhat elusive.

Eyeballing the Chart

Human brains are excellent at processing visual information, so why can't we just look at the chart of a share price and predict the next movement? Since we accept that the chart contains almost all the information we need, then it should be possible, surely?

There is nothing wrong with trying this, so lets do it - open up a Stock Chart for a favourite stock, save it as a bitmap, then open up the saved bitmap in your favourite paint program. Look at the sequences of uptrends and corrections; try colouring these in, shading like with like. After a while you should start to see some pattern emerge. Once you start to see order, try extrapolating the sequence into the future, it should not be too difficult. You might see, for example, a major downtrend followed by two mini-uptrends, then the cycle repeated ... whatever.

By now you should have produced a quite plausible looking set of future moves for your stock. Now look again, and modify your choices - try predicting again; chances are within a reasonable margin of error you have two quite distinct future histories; qualitatively they look the same, but they are displaced in some way. Now consider a trading strategy based on this 'prediction' - but which prediction is the more likely of the two? Chances are, the success of any trade you want to make will depend strongly on which prediction is the right one. What you would then want, is some probabilistic estimate of the likelihood of each; if you are trading options, then the probability of achieving a certain price value on the expiry date is what you really want. Alas, eyeballing the chart, does not give you this.

This approach to chart analysis is unreliable because our brains are only doing qualitative pattern recognition, exact timings and strengths of moves are not possible to judge, nor are probabilistic estimates either. What is more, there are psychological traits which further hinder us - we sometimes see order where there isn't and once we perceive a pattern, we will tend to ignore new information which doesn't fit in with our theory.

You can only get the probabilities by doing a simulation. Trade with the probabilities, not instinct.