Glossary B

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.

A | B | C | D | E | F | G | H | I | J | K | L | M | N | O | P | Q | R | S | T | U | V | W | X | Y | Z

B

Back-end Load

Sales commission charged at the time of redemption rather than at the time of purchase. The opposite situation is termed a front-end load, which is more common among pension fund charges, and which can result in very poor performance. In general, it is better having a back-end load than a front-end load; with a front-end load, the charges are being compounded.

Back Testing

Testing a model against past data. Back testing is easy in StockWave - you just select some data and run an algorithm against it; the output predictions can then be checked against what actually happened.

Back testing is a good way to discover suitable parameter values for the analyzers; e.g. suppose you want a prediction for next month - you are using the previous 3 months data and have been playing around with various choices, and getting results which are in disagreement. What you could do is to take data for the 3 months previous to last month, then vary the parameters until you get a reasonable prediction for last month; now try these parameter values for the last three months to get your prediction. Note that this technique is not foolproof - nothing is - but can work quite well.

The reasonableness of using back-testing in model selection is that we do not expect the underlying process, i.e. the generative model itself, to change very much over time. Of course, it is possible and likely even, that the 1972 behaviour of the Dow Jones is nothing like the 2004 behaviour - the dynamics of the market will have changed, but the difference between the June and July 2004 behaviour will not be that great.

Share prices can change a lot in a month, so what do you mean the differences will not be that great ...

Yes, that is right, but we do not expect the underlying model to change. Consider for a moment, physics - the study of the universe as it is; the goal of physics is to find the laws that govern the universe - these laws, i.e. mathematical models, that we find are called laws because they do not change over time - the law of gravity does not change from month to month. As far as we can see, there are no universal laws about the stock market, and the models which we build are only effective, if at all, for a short time.

Back-Propagation

A common type of neural network - the basic workhorse of the genre. Structurally it consists of a number of interconnected layers, each layer being made up of a number of processing elements. The network is trained by applying {input, output} pairs of training data, known as facts, then adjusting the interconnection weights according to the training algorithm.

Backwardation

A term relating to futures trading - the opposite of contango.

Bad Publicity

News which will depress a share price.

Bail Out, Government

An emotionally-charged phrase.

Large companies sometimes get into difficulties, then go crying to the government to 'bail them out' - i.e. cover or write-off their losses, or give them some money in some other way. Of course, it is never expressed in such terms - and using such language can result in a very bitter response indeed. Most companies in trouble will see themselves as special cases, and will say very angrily that it is 'not a bail-out'.

Unfortunately, rather than let the free market work as it is supposed to - unprofitable companies should fail, and should be allowed to go bankrupt - governments often do bail the company out, usually to avoid unpleasant political repercussions - workers losing their jobs, or as is more common, earning the ire of the City. Of course, it is the taxpayer who ultimately pays for this 'corporate welfare'.

It should be noted that while companies often ask for taxpayers money when times are hard, in the form of a bail-out (or its cousins, the tax-break and the subsidy) there is never any desire to offer the taxpayer a dividend or a profit-share when times are good. In theory, profitable companies will benefit society as a whole through the taxes levied on these profits, but this is often not the case; many highly profitable corporations largely avoid being fairly taxed via the use of offshore financial structures.

Balance Sheet

The numbers in the company report - the 'bottom line'.

Common terms you might see quoted are -

Market Capitalisation = number_of _shares*share_price = the total worth of the company on the market
Price to Book = market cap. / shareholder funds
Price to Sales = market cap. / annual sales
Profit Margin = profit after tax / annual sales
PE Ratio = market cap. / profit after tax; (low is good)
Gearing = net debt / shareholders funds; (high is bad)
Enterprise Value = market cap. plus debt

If in doing any analysis based on these, and other, so-called 'fundamentals' one should consider the totality of the data, and its relative comparison with that of other companies in the same sector; individually these numbers mean very little, especially as they can be subject to gross manipulation.

Banana Republic

Various, usually Latin American or Central African countries with military-led or militaristic governments and poor human rights records. The economic aspects of these regimes usually involve control of their natural resources by foreign corporations and a massive national debt, typically run up by buying expensive weapons they do not need or else on moderately-priced weapons which they will use against their own citizens; places you would neither want to live-in nor visit.

Barrier Option

A type of derivative. A barrier option is exercised when the underlying price crosses a trigger level - the barrier.

These kind of options are a step up in complexity from vanilla options and as such are somewhat too exotic for the small investor; also, they are a little bit ... sneaky. For an ordinary option the important thing to have a handle on is the probability above or below the breakeven value on the exercise date - with barriers it is more complicated; the barrier can be triggered by any single crossing within the time period, so the path of the share price is important, not simply where it ends up. If the underlying security has enough volatility, then barrier options may be a great deal more likely to trigger than one might naively think. Pricing of barrier options could still be done via the techniques found in StockWave, but it would require some modification, and is not considered.

In general, the financial whizzkids are forever inventing new types of ever more exotic derivative to tempt the buyer; the more exotic, the less likely the buyer is to properly understand them, hence the advantage lies with the seller. The golden rule in these situations is a simple one - if you do not understand what you are buying, then walk away.

Bear

Someone who believes the market will fall. A bear market is thus one in general decline.

Bear Call Spread

An options trading strategy; the trader sells a lower strike price call and buys a higher strike price call; the trade has both limited profit and limited risk.

Bear Put Spread

An options trading strategy; the trader sells a lower strike price put and buys a higher strike price put.

Betting

Staking money on the outcome of an event with odds gained from a bookmaker; basically, the punter is trying to make money in the short term, which is seen as bad and a social evil, and is even illegal in some places; usually the pastime of the working classes, it is not as respectable as investing - which is seen as socially responsible and a 'good thing'. Of course, betting, investing and speculating are all, really, functionally identical and what is more, the distinction is becoming ever less obvious as bookmaking firms extend themselves into financial betting and brokers realise that the investor needs more attractive trading opportunities than the simple buying-of-stocks.

Bid Price

The price at which you can sell - 'Bid to get Rid'

When trading shares, or any kind of security, there are always two prices, the bid and the offer; the offer price is what you will pay to e.g. buy a stock, the bid is what you get when you sell. Obviously, the offer price is always higher than the bid price (- except in very exceptional circumstances); the difference between them is known as the spread, and equally obviously, the smaller this is, the better for the investor. Spreads exist to allow the market makers to make a profit; the job of the market maker being to 'make' a market, i.e. create liquidity - the ability of the security to be both bought and sold; markets don't work otherwise.

Prices quoted on free data services are usually mid-prices, so if you want to estimate the bid/offer prices you should factor in, say +/- 0.3%; if you need an actual price, you have to phone a broker. Spreads vary, so shop around.

Black-Scholes Model

An options pricing model, developed by Black, Scholes and Merton. It tells you what an option is worth, in theory; with this formula we would hope to identify 'under-priced' options.

It is difficult to overstate the impact of this formula on the world of derivatives trading; when it came along it was regarded as being 'startlingly accurate' and was perhaps the first real breakthrough in financial mathematics. For the first time, traders could have confidence in what the value of an option was - this led to a surge in derivatives trading and lucrative job opportunities for PhDs in maths and sciences, which continues to this day.

The derivation of the formula involves regarding the underlying share price as a continuous markov process, and making the following assumptions -

The stock pays no dividends during the option's life
European exercise terms are used
Markets are efficient
No commissions are charged
Interest rates remain constant and known
Returns are lognormally distributed

In the hands of a trained mathematician, the final result is a type of diffusion equation (- a variety usually found in the theory of heat transport), and most importantly, one which allows its solution in a relatively neat formula -

call_premium = current_price * N1 - strike_price * exp (- interest_rate * time_left_to_expiry) * N2

How to explain what this means?

Well...if you look at the equation you will see that what you should pay to own the option depends on the current price and the strike price, as you might expect, multiplied by statistical terms N1 and N2 which, to put it crudely, represent the likely movement of the share price, plus a time decay factor in the final term. So e.g., at expiry the second term will simply be the strike price and the first term will be the current price - which makes sense; the fair value is simply the difference between the prices.

Note that strictly speaking, all of the model assumptions are false; one can have a very good argument over whether the assumptions can be justified or not - all we can say is that some are easily adjusted for, others not so -

Most companies pay dividends to their share holders, but the model can be altered in this case by subtracting the discounted value of a future dividend.
European options can only be exercised on the expiration date while American options can be exercised at any time during the life of the option; this is not a real problem since most American calls are only exercised very close to their expiration date; this is because when you exercise early, you are losing the time value of the option.
Markets are not perfectly efficient but are instead 'quite efficient'. Exactly how efficient one needs markets to be for the assumption to be a good one, is not clear.
Commissions can wipe out your profit; this is a big issue for the smaller investor.
There is no such thing as the 'risk-free interest rate'.
Returns have 'fat tails'. This means that real share prices are subject to a more severe form of randomness than in the model.

Anecdotal evidence suggests that Black-Scholes over-estimates the value of in-the-money options and under-estimates the value of out-the-money options (- for an excellent and highly insightful exposition of the deficiencies of the Black Scholes model you should get hold of the paper 'The Holes in Black Scholes' by Fischer Black.)

Despite the hype surrounding this model, it is really only an application of the theory of Brownian Motion; Einstein worked this out at the turn of the last century (- his first major piece of work), some 60-70 years before Black and Scholes.

To end the story, the inventors won the equivalent of the Nobel Prize for Economics (- there is no actual award for economics) and proceeded to go on to create their own hedge fund, Long Term Capital Management, which made amazing investment returns for super-rich investors until the day they got it very badly wrong and nearly destroyed Capitalism itself.

Pricing of options is done automatically in StockWave via the use of the probabilistic predictors (- generated by Monte Carlo simulation), and the payoff graph - you don't need the Black-Scholes equation. StockWave makes no assumptions whatsoever; it simply measures what is, then takes it from there.

Black Hole

Not a "collapsed star whose mass causes such extreme gravity that not even light can escape from it", but instead an accountancy colloquialism - it refers to a large deficit in the accounts; a place where there should be something, but isn't; a massive shortfall. In practice, black holes are either due to extremely optimistic financial planning at the outset of an enterprise, which ends up leaving a funding gap, or due to fraud - i.e. money has just been 'disappeared'. Stolen. Nicked. Pilfered.

One commonality with the black holes of astrophysical origin, is that when matter -or money- falls into them, it is never seen again.

Blame

'It wasn't me - a Big Boy did it and ran away!'

The childish protestations of my youth flush me with such nostalgia ..., but getting back to the point - no one likes to take the blame, much better if it is someone else's fault - when the shit hits the fan in the markets, the Blame Game starts with a vengeance, the views expressed being barely above the childish level of small boys, for example -

Investors blame analysts for giving lousy, partisan advice.
Analysts blame their employers, the investment banks for pressurizing them into being positive on crappy-arsed stocks.
Auditors are bent, totally cowed to their corporate paymasters.
Accountants are dodgy, unwilling to jeopardise lucrative consultancy work.
CEOs bloated with stock options inflate earnings figures.
CFOs collude with their CEOs to fabricate these inflated forecasts.
Hedge Funds and speculators who short-sell the market are to blame for massive drops.
Daytraders, who don't understand the markets, create volatility.
The government is to blame for business-unfriendly policies.
Derivatives caused it, absolutely no doubt.
Rumours posted on the Internet caused it.
The government is to blame for being in the pockets of big business.
Whatever it is, its not my fault, don't ask me - I don't know, and if I did, I probably don't remember exactly what happened. Please conduct any further enquiries through my attorney ...

And etc. The only excuses which don't seem to be used are low self-esteem and the lack of a male role model - which is a nice change. Everyone sues everyone else and sits tight, hoping the government will bail them out with taxpayers money - then its back to business as usual.

Blue Chip Stocks

The biggest companies listed on an exchange, e.g. the Dow Jones, FTSE 100 or Eurostoxx 50; large multinational, multi-billion dollar corporations.

The term comes from poker where the blue chips have the greatest value.

Book Value

This is assets minus liabilities (- shareholder equity per share); e.g. land, property, inventory, cash minus e.g. debts. Should give an indication of the liquidation (- break-up) value of the company.

The problem with this number lies in deciding exactly what is defined as an asset, and what its value actually is - the usual accountancy tricks apply. To be believable one has to have some confidence that the assets listed could be sold off relatively quickly for the cash value they are listed at. Obviously, there are some heavy assumptions being used here.

Almost meaningless in practice.

Bond

A bond is, basically, an IOU. The value of which therefore depends on the credit-worthiness of the issuer.

Bond markets are sometimes referred to as the 'Fixed Income' sector.

Boom and Bust

Stock prices shooting up, then crashing back down again. A natural cycle which despite the best attentions of governments and central bankers, we cannot get rid off.

Bounded Variation

A mathematical term - it means that when we look more closely at a function, it becomes better behaved - smoother, straighter. This important feature is the reason why some mathematical techniques are possible in many situations, e.g. a lot of the time we can approximate an unknown function with a smooth curve, which we know how to manipulate. The opposite situation is where this 'better behaviour' does not arise no matter how closely we move in - share prices would seem to have this nastier, wilder behaviour; they always seem 'jaggy' no matter what scale we observe them at, the only limiting factor being the maximum resolution of the data feed.

Broker

A stockbroker - someone who sell stocks.

Brokers make their money - and it is a very good living indeed - by charging commission, which can be a flat rate or a sliding percentage - the more stocks you buy, the less you might have to pay. Good customers may get preferential rates. Some brokerages also give advice, but considering that ultimately a broker wants to sell you stock, you can imagine what the value of this is. If you are on good terms with your broker, you may have the facility to short-sell also, thus giving you more flexibility in your trading strategy.

Broker Recommendations

Usually buy, and almost never, ever, a sell. All things being equal, one might expect these to be equal in number. Other recommendations comprise meaningless waffle like: accumulate carefully, or firm hold. If a broker really knew something important about a company, then he shouldn't - the only worthwhile information is insider information, and if he does know something, why would you expect him to offer it for free?

Bubble Dynamics

If you are a keen watcher of financial affairs you will be aware of the phenomenon of the Bubble; this is when valuations of some asset become extremely exaggerated, but persist and grow for a considerable period, eventually however, the bubble 'bursts' and prices revert to more reasonable levels. Bubbles are very destructive phenomena, especially to the small investor. What is particularly worrying is how this phenomenon seems to recur and spread across successive markets - they appear everywhere. Dealing with bubbles poses severe problems for current market orthodoxy, for according to the Panglossian worldview of Adam Smiths free and perfect market, bubbles should not exist - the invisible hand should disrupt them before they even appear.

So much for orthodoxy - does anyone really understand what is going on??

To be honest, we don't know, so ... let's work our way around the problem, discuss its features and then try to formulate some easier questions that we can attack ...

Can you identify a Bubble?

Alan Greenspan famously said something like "bubbles are only identifiable after they have burst" - which is little bit like saying "Ponzi schemes are only identifiable once everyone has been bilked, and the founder has all the cash ..." Most normal people would tend to disagree with this - in the real world we are used to seeing systems which are under stress and then collapsing once some threshold has been reached, that is to say, there is a measurable parameter to which we can look for information. In theory one could try and identify some parameter which could describe the bubbles we see in the various markets, but although finding plausible indicators is not overly difficult, developing a theory around them with which to describe the stress of the given bubble, and more importantly, the critical point at which it will collapse, is. Very much so.

In the stock markets we could take the price to earnings ratio as a parameter - this is a measure of how much one is paying for a given unit of company profit. In bubble periods PE ratios can become absurdly high. Although there are rules of thumb for what a reasonable PE ratio is, these may vary across sectors. In short, this number does not seem to be a reliable indicator; ideally one would like to simply say - "... PE ratios for this market are crazy, this bubble is about to pop ..." - then short a lot of stock making huge profits in the process, but alas this strategy could leave you seriously burned.

In the housing market we could look at the ratio of average house price to average yearly earnings - this is a good candidate, especially considering that the maximum mortgage allowed by lenders is only 3 times earnings. Obviously then, anything close to 3 for an overall average is becoming stressed. The trouble is, this number is over 5! Even more troublesome ... it has been for some time!! The immediate extra factor here is interest rates - because they have been very low, the affordability factor, i.e. average monthly repayment on average house to average salary, is historically low. Unscrupulous lenders have also allowed the abuse of 'self certification' of salary by mortgage applicants; a nod and a wink, an acceptable number is suggested, but no background checks are done. Other practices have included the popularisation of 'interest only' mortgages and 100% mortgages (- i.e. no downpayment or deposit needed). Competition is fierce, lenders will lend to almost anyone.

Of course, if interest rates shoot up, lots of people will start feeling the pain, but its wrong to reason this will lead to a crash simply from the viewpoint of 'affordability' - after all this depends on all the 'other stuff' that is coming out of the persons salary, i.e. other loans, food and energy bills. Most people will sacrifice lifestyle before their house, their 'castle' - so we also need to take account of consumer spending (- a measure of 'lifestyle') and energy prices, i.e. oil. Our attempt to build a model is starting to flounder; even if somehow we could get together a good data-set, the predictions will likely be all over the place.

There are even more difficulties to deal with; so far we've been using 'averages' but these don't tell us the whole story, in fact it may be the distribution of extreme cases (- how many people are really out of their depth, or close to it) which are most important when triggering a cascade effect, leading to a widespread crash. The housing market also has its own idiosyncrasies - it is very localised, varying greatly area by area, buying and selling property is a slow process.

Why don't obvious bubbles burst? How can they persist for so long?

Like in our discussion of the housing market above, it is clear that when there are several parameters in the model, it is very hard to make headway. Instead of looking for a critical point, we have to deal with a critical (hyper-) surface and the range of stable/quasi-stable behaviour is so much greater.

Let's look at a physical model as an analogy - a system with sudden, unexpected behaviour between long periods of stable, yet apparently unstable, states -

When I was a child I'd go to the amusement arcade - electronic games had only just appeared, so most were mechanical; one I particularly liked was called the Penny Falls - it was 3 stepped platforms, oscillating to and fro irregularly against each other, each platform was covered in coins, so when the platforms moved some would fall from the top to the bottom; the bottom layer usually had a large collection of pennies built up into a vicious overhang over the payout bucket. The object of the game was to aim a penny along a rail onto the top layer in such a way as to trigger a successive falling of pennies from layer to layer - you were trying to make the overhang at the bottom collapse so that e.g. one penny in, would lead to 30 or 40 pennies in return.

The thing about the Penny Falls was how it was easy to convince oneself that the bottom overhang was 'ready to fall at any moment' and the sense of surprise and frustration as successive pennies were aimed, yet seemed to have no effect - 'why won't that bloody overhang collapse!' Then, usually when one was becoming convinced it had been glued in place by an unscrupulous operator, it would fall. It was always a surprise. Always.

When examing the system there is a tendency to concentrate on the size of the overhang - this is the most obvious thing to do, but then we become psychologically fixated upon it to the exclusion of other factors. The pennies tend to spread out when landing on a layer, filling up any gaps that are available, and when there aren't any, they will slide over each other; the friction between the pennies plus the weight of those lying on top presses down, holding the lower ones in place and so provide a counterbalancing force to the overhang, so there is more stability and significantly more holding capacity than one might imagine. But the system is only quasi-stable and will still collapse, eventually.

Just because the dynamics of a bubble are more subtle and complex then one can envisage, does not mean its not a bubble anymore; it is still a bubble, except that the final transition it makes will be even more unpredictable and serious than you can imagine; even more reason for you to stay away from any involvement. When the cheerleaders start carping on about 'soft landings' 'new paradigms' or 'this time its different' - do not believe it; a bubble is still a bubble.

Can you stop Bubbles?

[- Now this is a very good question!]

In theory I suppose so, yes, well maybe, or maybe not ... it is in fact one of the things the central bankers are meant to do on behalf of their political masters, but they also need to grow the economy otherwise everything starts to unravel (- our economic system needs growth to remain stable.) Politicians obviously want to keep their jobs, so growth is the target. Naively chasing growth leads to cycles of Boom and Bust - which is what we don't want, hence it is the considered aim of all politicians to generate steady growth, with all the nasty ups and downs, and bubbles and booms and recessions, smoothed away.

A famous quote about the role of the central banker is something like "take away the punchbowl once the party gets started". Another famous quote is by Mr Greenspan again who once talked of "irrational exuberance" of the markets, then proceeded to spike the punchbowl at his particular party. So much for famous quotes.

What people are supposed to do or say they are doing, and what they are actually doing are often in violent disagreement. Central bankers have a lot of power, access to the best information and analysis; they are also very secretive and have lots of meetings with each other to coordinate on an international level, e.g. at the BIS; when they do talk to the public they do so with a zen koan-like opacity designed to confuse the great unwashed while, perhaps, sending subtle signals to the enlightened ones.

If its not all a big conspiracy, then why do they make it look so obviously like it is a big conspiracy ... ?!

This is not an unreasonable question, but its unwise to get into the wilds of speculation-land. (Having said that, if you want something juicy, try reading about Montague Norman, head of the Bank of England in the early part of last century - he was a very strange man, given to cloak and dagger shenanigans, not unlike some kind of proto-Bond villain, e.g. his desk had a secret switch which could flood the banks vaults in an emergency!)

Officially then, central bankers are apolitical, lacking any personal agenda - mere public servants serving the general interest of us all by trying to bring growth and stability to our economies, and not the "high servants of the elite carrying out their nefarious agenda".

I'm glad we've got all that sorted out ...

But still, ... with all the resources they've got - the Ivy League 'big brains', the information streams, the fancy computers - their track record of bubble prevention is not good at all. Of course, one might argue, that without their intervention everything would be ten times worse than it is, and that really they are doing a splendid job - were they less secretive we may, in fact, be able to give them a lot more credit and respect than we do so currently.

Maybe, we're still asking the wrong questions?

[Cui Bono:] Does anyone benefit from Bubbles (theoretically, hypothetically)?

Yes. Very much so. If you knew their timing you could profit by buying on the way up *and* then by selling on the way down, *and also* when everything was back down at rock bottom, you could then go on a shopping spree, buying up real assets, for an absolute song; its a triple-whammy slam-dunk saccharine-overload sweet-sweetbacks-badass-deal-of-the-century ...!!

The only thing you need then to bring off such a coup is greater insight, luck or information than anyone else. Greater insight would call for actually building a model, to start with you would need a bunch of PhDs, a supercomputer, access to vast streams of realtime information and a lot of time; most folks are lucky to have O Grade Maths, a Pentium PC and BT (not-very) broadband. If you believe in Luck, then why not try the Lottery, give all this complicated stuff a miss; someones got to win that £1 million prize - it could be you! Information - and I don't mean the drivel you get in newspapers, finance Web sites, TV shows or even investment magazines - is what you really need; high quality information known only to well-connected insiders, e.g. changes of direction in monetary policy, or the first warning signs of impending trouble.

The 'better informed', or 'sophisticated' can thus afford to ride the tiger all the way to big profits; hypothetically, if you were in this position, you would not actually care about bubbles, quite the opposite, you would relish the opportunities they present; sophisticated investors are also usually diversified, and can move their money in and out quickly at the first signs of trouble. As long as the people-that-really-matter can get to the lifeboats first, there is no real interest in eliminating bubbles; worrying the general public is just likely to cause a panic.

In the book 'Wall Street' by Doug Henwood, an anonymous trader is quoted as saying:

"Anyone who doesn't know something no-one else knows is a fucking chump ..."

- the general public are just that; a bunch of 'fucking chumps' whose wellbeing, financial or otherwise, is of no interest whatsoever to those with real power.

Bull

Someone who believes the market will rise. A bull market is thus one where share prices are generally rising. Everyone loves bull markets because it is so easy to make money - just buy almost anything at all and the chances are it will go up in value; there is always lots of deal-making and piles of cash floating about - the lucky City Boys get rich on fat fees and commissions plus their huge Christmas bonuses. Its really easy.

One of the problems with a long bull run is that hardly anyone is willing to believe it will come to an end; most City Boys are pretty young - the idea is to come in, work the high-stress/long-hours culture for about 10 years then retire in ones early 30s - the so-called 'fast burn'; to these young men, bear markets existed only as a theoretical possibility (- you know they exist, but you've never actually seen one yourself) - you would have had to have been 'really old' to remember back the last time.

With this conditioning of expectation, every new low is seen only as a 'blip', a 'correction' or as an 'adjustment' - you start to disbelieve your own senses; when it starts to hit home, it is too late. BTW - anyone who wishes to blame the problems of the markets on Osama, Enron or Andersen, should take a good look at the charts - the rot had set-in well before these events.

Bull Call Spread

An options investing strategy; the trader buys a lower strike price call and sells a higher strike price call.

Bull Put Spread

An options investing strategy; the trader sells a higher strike price put and buys a lower strike price put.

Butterfly Spread

Selling (buying) two identical options, together with the buying (selling) of one option with an immediately higher strike, and one option with an immediately lower strike. All options are the same type, with the same underlying and the same expiration date.

Buy and Hold

This is an investment strategy that doesn't really impress us; you simply buy a 'good' stock, and hold onto to it for a long period, usually many years.

The idea is that over the long term, the fluctuations of the market will cancel each other out, i.e. in the short term, which is any period less than years, one simply ignores what the stock is doing, whether good or bad, safe in the knowledge that whatever is going on is merely a 'fluctuation'. This is the kind of strategy that takes brave men - the questions you must ask are -

When does a 'fluctuation' become a 'trend', and
What is a 'good' company in the first place? (We don't know!)

But there is some justification for this strategy - take a look at the chart of one of the indices; the data goes back almost 20 years - and you will see how it shows geometric growth, mostly - when you zoom in you will see a different story, but that is entirely the point - one simply ignores the short term issues. The charts of the major US blue chip stocks also show this very clearly.

The obvious problem of picking an individual 'good' stock to invest in can be resolved to an extent by choosing a collection of stocks to spread the risk - a portfolio. But even choosing the right collection of stocks is still very difficult; this rather tricky business of stock-picking was apparently resolved in the late 1990s by the idea of index tracking; observing that most professional stock-pickers, i.e. the fund managers, as a group were incapable of beating the overall market index, the fashion was to buy a tracker fund, since "whatever happened to individual stocks, the overall index would go up, right?!" Well, no, not really, but the buy-and-holders would still argue that one should simply bitter out the bear market, as a bull will follow shortly.

These are some reasons to believe the buy-and-hold argument, but there are also strong counter-examples - e.g. Enron and Marconi, two cases which show how even once large and highly-respected, blue-chip stocks can go all the way down to the floor. As for indices, the Japanese Nikkei has been going sideways for an entire decade at around the 10000 mark, while falling from an all-time high of around 40000 - the buy and hold argument relies on there being another bull market coming along soon after, should a bear arise for a year or two; in Japan this hasn't happened - waiting for the upturn could turn out to be a bit like Waiting for Godot.

So when does the buy-and-holder finally run for cover? Theoretically, he doesn't - but in practice, the answer is that he usually gets out far too late.

It is generally regarded as being part of the received wisdom of investing that Warren Buffett uses buy-and-hold, but is not strictly true; there is a lot more to his strategy than that - while there are a few 'inevitables' as he calls them, many stocks are held for only a couple of years. It should also be pointed out that Berkshire Hathaway (- his company) do an incredible amount of their own research on a company before they go anywhere near it; they also buy entire companies as investments - this is one sure-fire way to make sure the company is being managed properly, and that the books have not been cooked. Buffett is clearly a sophisticate, but seems to enjoy and accept the public relations benefits of his received image - folk-wisdom and home town values from the 'Sage of Omaha' whose traditional commonsense is superior to the whizz-kid rocket science of Wall Street! Ordinary folks love this kind of thing, and if it helps his business, why not?

In summary, we regard the buy and hold strategy as being nothing more than over-optimistic laziness.

Buying on Margin

This means using borrowing to finance your trading. The reason for doing this would be to create leverage on a trade, i.e. to multiply the expected profit level. It is, on the whole, pretty dangerous and should only be used for short term trading scenarios. We do not recommend it. If you decide to use this tactic, be very aware of your total exposure, and basically - just don't get out of your depth. Remember that in short-term leveraged-trading, positions can change very quickly indeed, so you need to monitor the situation very closely.

"Buying on margin" sounds rather too anodyne in our opinion, so if you are tempted - for whatever reason - substitute the phrase 'borrowing to gamble' - then ask yourself whether you still want to do it. Generally speaking, do not gamble/invest/speculate with money you cannot afford to lose.

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