GLOSSARY

Algorithm A rule or set of rules for computing; that is, a procedure for calculating a mathematical function.

Arbitrage Taking advantage of discrepancies in price or loopholes in the system to make consistent low-risk money. This strategy usually involves the simultaneous purchase and sale of related items.

Asset allocation The procedure by which many professional traders decide how to allocate their capital. As a result of the lotto bias, many people think of this as a decision about which asset class (such as energy stocks or gold) to select. However, its real power comes when people use it to tell them how much to invest in each asset class. Thus, it is really another term for “position sizing strategy.”

Average true range (ATR) The average over the last X days of the true range, which is the largest of the following: (1) today’s high minus today’s low, (2) today’s high minus yesterday’s close, and (3) today’s low minus yesterday’s close.

Band trading A style of trading in which the instrument being traded is thought to move within a range of prices. Thus, when the price gets too high (that is, overbought), you can assume that it will go down. When the price gets too low (that is, oversold), you can assume that it will move up. This concept is discussed in Part 5 of this book.

Bearish Of the opinion that the market will be going down in the future.

Breakout A move up from a consolidation or band of sideways movement.

Bullish Of the opinion that the market will be going up in the future.

Commodities Physical products that are traded at a futures exchange. Examples are grains, foods, meats, and metals.

Contract A single unit of a commodity or future. For example, a single unit or contract of corn is 5,000 bushels. A single unit of gold is 100 ounces.

Discretionary trading Trading that depends on the instincts of the trader, as opposed to a systematic approach. The best discretionary traders are those who develop a systematic approach and then use discretion in their exits and position sizing strategies to improve their performance.

Divergence Two or more indicators that fail to show confirming signals.

Diversification Investing in independent markets to reduce the overall risk.

Drawdown A decrease in the value of your account because of losing trades or because of “paper losses” that may result from a decline in the value of open positions.

Entry The part of your system that signals how or when you should enter the market.

Equal units model A position sizing model in which you purchase an equal dollar amount of each position.

Equities Stocks secured by ownership in the company.

Equity The value of your account.

Exit The part of your trading system that tells you how or when to exit the market.

Expectancy How much you can expect to make on average over many trades. Expectancy is best stated in terms of how much you can make per dollar you risk. Expectancy is the mean R of an R-multiple distribution generated by a trading system.

Filter An indicator that selects only data that meet specific criteria. Too many filters tend to lead to overoptimization.

Financial freedom A financial state that occurs, according to Van Tharp, when your passive income (income that comes from your money working for you) is greater than your expenses. For example, if your monthly expenses total $4,000 and your money working for you brings in $4,300 per month, you are financially free.

Floor trader A person who trades on the floor of a commodities exchange. Locals tend to trade their own accounts, and pit brokers tend to trade for a brokerage company or a large firm.

Forex Foreign exchange; a huge market in foreign currencies made by large banks worldwide. Today there are also much smaller companies that allow you to trade on the foreign exchange, but they take the side of the bid-ask spread opposite from yours.

Fundamental analysis Analysis of the market to determine its supply and demand characteristics. In equities markets, fundamental analysis determines the value, the earnings, the management, and the relative data of a particular stock.

Futures A contract obligating its holder to buy a specified asset at a particular time and price. When commodity exchanges added stock index contracts and currency contracts, the term was developed to be more inclusive of those assets.

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 exists, but the real meaning of the Holy Grail is right on track: it suggests that the secret is inside you. In addition, as we’ve described in this book, you can easily design a Holy Grail system if it is specific to one market type.

Indicator A summary of data presented in a supposedly meaningful way to help traders and investors make decisions.

Investing Refers to a buy-and-hold strategy that most people follow. If you are in and out frequently or are willing to go both long and short, you are trading.

Leverage The relationship between the amount of money one needs to put up to own something and its underlying value. High leverage, which occurs when a small deposit controls a large investment, increases the potential size of profits and losses.

Liquidity The ease and availability of trading in an underlying stock or futures contract. When the volume of trading is high, there is usually a lot of liquidity.

Long Owning a tradable item in anticipation of a future price increase. Also see short.

Low-risk idea An idea that has a positive expectancy and is traded at a risk level that allows for the worst possible situation in the short term so that one can realize the long-term expectancy.

Martingale strategy A position sizing strategy in which the position size increases after you lose money. In the classic martingale strategy, you double your risk size after each loss.

Maximum adverse excursion (MAE) The maximum loss attributable to price movement against the position during the life of a particular trade.

Mechanical trading A form of trading in which all actions are determined by a computer with no human decision making.

Mental rehearsal The psychological process of preplanning an event or strategy in one’s mind before actually doing it.

Modeling The process of determining how some form of peak performance (such as top trading) is accomplished and then the passing on of that training to others.

Money management Used to describe position sizing strategies. However, this term has so many other connotations that people fail to understand its full meaning or importance. For example, the term also refers to (1) managing other people’s money, (2) controlling risk, (3) managing one’s personal finances, and (4) achieving maximum gain.

Negative expectancy system A system in which you will never make money over the long term. For example, all casino games are designed to be negative expectancy games. Negative expectancy systems also include some highly reliable systems (that is, those with a high hit rate) that tend to have occasional large losses.

Neuro-linguistic programming (NLP) A form of psychological training developed by the systems analyst Richard Bandler and the linguist John Grinder. It forms the foundation for the science of modeling excellence in human behavior. However, what usually is taught in NLP seminars are the techniques that are developed from the modeling process. For example, we have modeled top trading, system development, position sizing strategies, and wealth building at the Van Tharp Institute. What we teach in our workshops is the process of doing those things, not the modeling process itself.

Opportunity See trade opportunity.

Passive income Income that occurs because your money is working for you.

Peak-to-trough drawdown Maximum drawdown from the highest equity peak to the lowest equity trough before reaching a new equity high.

Percent risk model A position sizing model in which position size is determined by limiting the risk on a position to a certain percentage of your equity.

Percent volatility model A position sizing model in which position size is determined by limiting the amount of volatility (which is usually defined by the average true range) in a position to a certain percentage of your equity.

Position sizing strategies The most important of the six key elements of successful trading. This is the part of your system that really determines whether you’ll meet your objectives. This element determines how large a position you will have throughout the course of a trade. In most cases, algorithms that work for determining position size are based on one’s current equity.

Positive expectancy system A system or game that will make money over the long term if played at a risk level that is sufficiently low. It also means that the mean R value of a distribution of R multiples is a positive number.

Prediction A guess about the future. Most people want to make money by guessing future outcomes—that is, by making a prediction. Analysts are employed to predict prices. However, great traders make money by cutting losses short and letting profits run, which has nothing to do with prediction.

Price/earnings (P/E) ratio The ratio of the price of a stock to its earnings. For example, if a $20 stock earns $1 per share each year, it has a price/earnings ratio of 20. Over the last 100 years, the average P/E of the S&P 500 has been about 17.

Random An event determined by chance. In mathematics, a number that cannot be predicted.

Reliability How accurate something is or how often it wins. Thus, “60% reliability” means that something wins 60% of the time.

Reward-to-risk ratio The average return on an account (on a yearly basis) divided by the maximum peak-to-trough drawdown. Any reward-to-risk ratio over 3 as determined by this method is excellent. This term also may refer to the size of the average winning trade divided by the size of the average losing trade.

Risk The difference in price between the entry point in a position and the worst-case loss one is willing to take in that position. For example, if you buy a stock at $20 and decide to get out if it drops to $18, your risk is $2 per share. Note that this definition is much different from the typical academic definition of risk as the variability of the market in which you are investing.

R multiple Trading results in terms of the initial risk. All profits and losses can be expressed as a multiple of the initial risk (R) taken. For example, a 10R multiple is a profit that is 10 times the initial risk. Thus, if your initial risk were $10, a $100 profit would be a 10R-multiple profit. When you do this, any system can then be described by the R-multiple distribution that it generates. That distribution will have a mean (expectancy) and a standard deviation that will characterize it.

R value The initial risk taken in a particular position as defined by one’s initial stop loss.

Scalping The actions of floor traders who buy and sell quickly to get the bid and ask prices or to make a quick profit. The bid price is what they will buy for (and what you’ll get as a seller), and the ask price is what they’ll sell for (and what you’ll get as a buyer).

Seasonal trading Trading based on consistent, predictable changes in price during the year that result from production cycles or demand cycles.

Secular (bull or bear) market Long-term tendencies in the market to increase valuations (bull) or decrease valuations (bear). Secular tendencies can last for several decades, but they say nothing about what the market will do in the next few months or even the next year.

Setup A part of your trading system in which certain criteria must be present before you look for an entry into the market. People used to describe trading systems by their setups. For example, CANSLIM is an acronym for the setup criteria devised by William O’Neil.

Short Not actually owning an item that you are selling. If you were using this strategy, you would sell an item in order to be able to buy it later at a lower price. When you sell an item before you actually have bought it, you are said to be “shorting the market.”

Sideways market A market that moves neither up nor down.

Slippage The difference in price between what you expect to pay when you enter the market and what you actually pay. For example, if you attempted to buy at 15 and end up buying at 15.5, you have a half point of slippage.

Speculating Investing in markets that are considered very volatile and thus quite risky in the academic sense of the word.

Spreading The process of trading two related markets to exploit a new relationship. Thus, you might trade Japanese yen in terms of British pounds. In doing so, you are trading the relationship between the two currencies.

Standard deviation The positive square root of the expected value of the square of the difference between a random variable and its mean. A measure of variability that has been expressed in a normalized form.

Stop (stop loss, stop order) An order you put with your broker that turns into a market order if the price hits the stop point. It’s typically called a “stop” (or a “stop loss order”) because most traders use it to make sure they sell an open position before it gets away from them. It typically will stop a loss from getting too big. However, since it turns into a market order when the stop price is hit, you are not guaranteed that you’ll get that price. It might be much worse. Most electronic brokerage systems will allow you to put a stop order into their computer. The computer then sends it out as a market order when that price is hit. Thus, it does not go into the market, where everyone might see it and look for it.

Support The price level that a stock historically has had difficulty falling below. It is the area on the chart at which buyers seem to come into the market.

Swing trading Short-term trading designed to capture quick moves in the market.

System A set of rules for trading. A complete system typically has (1) some setup conditions, (2) an entry signal, (3) a worst-case disaster stop loss to preserve capital, (4) a profit-taking exit, and (5) a position sizing algorithm. However, many commercially available systems do not meet all these criteria. A trading system also may be described by the R-multiple distribution it generates.

Trade distribution The manner in which winning and losing trades are achieved over time. It will show the winning streaks and the losing streaks.

Trade opportunity One of the six keys to profitable trading. It refers to how often a system will open a position in the market.

Trading Opening 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.

Trading cost The cost of trading, which typically includes brokerage commissions and slippage, plus the market maker’s cost.

Trailing stop A stop loss order that moves with the prevailing trend of the market. It typically is used as a way to exit profitable trades. The stop is moved only when the market goes in your favor. It is never moved in the opposite direction.

Trend following The systematic process of capturing extreme moves in the market with the idea of staying in the market as long as the market continues its move.

Units per fixed amount of money model A position sizing model in which you typically buy one unit of everything per so much money in your account. For example, you might buy one unit (that is, 100 shares or one contract) per $25,000.

Validity How “real” something is. Does it measure what it is supposed to measure? How accurate is it?

Valuation An exercise in giving some value on the price of a stock or commodity that is based on some model for determining value. See value trading.

Value trading A concept in which positions are opened in the market because they have good value. There are numerous ways to measure value. A good way of thinking about it is that if the assets of a company are worth $20 per share and you can buy the company for $15 per share, you are getting a good value. Different value traders have different ways to define value.

Volatility The noise around the market, usually defined by the average true range of a fixed number of days. Bear markets tend to be associated with higher volatility and thus are more difficult for investors.