It's been a couple months since we've had to update this guide, but the markets were a sea of red on October 10, 2018 with the DJIA falling more than 800 points or 3 percent and the Nasdaq tumbling more than 4 percent. The Federal Reserve hiked rates which was expected but President Trump's comments about that were not. At the same time, Treasury yields have hit multi-year highs and the IMF has expressed concerns about global financial stability in an environment of trade wars. All these factors have made stock investors jittery and compelled us to freshen it up.
Stock sell-offs are tough for long-term buy and hold investors to swallow. But, they are a necessary and natural element of a functional marketplace. Laws of supply and demand and investor appetite fuel uptrends and downtrends alike. We just have to be aware of them as investors and plan accordingly. Sell-offs also conjure up a special vocabulary of finance and investing words in the financial media that a lot of people don't hear very often. That's why we are here. Here is a cheat sheet of some of those terms the next time you find yourself in a downdraft and want to decode the finance-speak:
Correction: Simply put, it's a 10% decline of the price of a security, market or index from its most recent high. Don't confuse it with crash or just a bad day in the markets. They happen fairly frequently and can last anywhere from a couple of days to several months. Stocks can be in a correction before the index they are in falls into one. For example, more than half of the stocks in the S&P 500 Index are in a correction, but the Index itself has yet to fall into one, as of October 10th, 2018.
Volatility: Technically speaking, it's a statistical measure of the dispersion or returns for a given security or market index. That's another way of saying it's a measurement of change or beta, as it is known, of a security or index against its normal patterns or benchmarks it is weighed against. In the stock market, one way of measuring volatility is to look at the VIX, the Chicago Board of Options Volatility Index. There are many other ways to measure volatility depending on what you are looking at or measuring, but if you think of it as a measurement of the rate of change which reflects uncertainty or risk, you are on the right track. At Investopedia, we created the Anxiety Index to measure the search volume of 13 of our fear-based terms associated with the markets, the economy and personal finance. In times of extreme volatility and market sell-offs like now, it is red hot.
Implied Volatility: This refers to the estimated volatility of a security's price and is generally used when pricing options. In general, implied volatility increases when the market is bearish, when investors believe that the asset's price will decline over time, and decreases when the market is bullish, when investors believe that the price will rise over time.
Short Selling: Basically, short selling is a bet that a security or index will decline wherein a short seller borrows shares to offer them for sale. The idea is to sell such shares, of which the short-seller has no ownership, at a higher price hoping that the price falls by the time the trade needs to be settled. That would enable the short-seller to acquire shares at the lower price and deliver them to the buyer, making a profit equaling the difference in prices. While, if done right, short selling could be profitable but could amount to massive losses if the trade goes the other way. It is definitely not a strategy for beginners.
Circuit Breaker: Kind of like the breaker box in your basement, except this one can shut off the juice at the major securities exchanges. Exchanges like the NYSE and Nasdaq are sometimes compelled to flip the switch when there is too much of an imbalance between sell and buy orders. With more and more trades being pushed through computer algorithms, those imbalances can be more frequent. They last anywhere from a few minutes to several hours, but its all in the name of smoothing out the order flow so markets can effectively match buyers and sellers.
Buy the Dips: This is trader slang for buying securities following a decline in prices with the inkling that they have fallen for no apparent reason and should recover and keep rising in short order. It's kind of like an unexpected sale at your favorite retailer except you think the value of the things you buy on that sale day will get more valuable over time. It doesn't always work out in the stock market, but people like saying it.
Capitulation: You can think of it as ripping your computer off the desk, hurling it across the room and throwing the mother of all tantrums... but really its another way of saying that you can't bear the losses anymore in a particular security or market and you are going to cut your losses and sell. When markets or a particular stock sells off in heavy volume, many investors are tempted to abandon ship and sell their stakes as well, or capitulate. That only exacerbates the losses.
Inflation: The recent market sell-offs have been attributed in part to fears about rising inflation. Simply put, inflation is the rate at which the level of prices for goods and services rise which can drive the purchasing power of a currency lower. The Federal Reserve pays particular attention to rising inflation when it sets overnight lending rates or the Federal Funds Rate, as it is known. Since the Fed has been raising rates of late and plans to continue to do so a few more times, at least, it makes borrowing costs more expensive which can impede growth and therefore profits. It may sound complicated, but you can understand the relationship between interest rates and stock markets.
Bond Yields: Rising bond yields are also being blamed for the sell-off in stocks. As the Fed raises overnight lending rates and the yield, or return, on U.S. treasury bond prices rise, it makes them more attractive to investors, large and small, who are looking for a safer and less volatile place to put their money than stocks. Bond yields have been so low for so long, but they are starting to creep higher, drawing more money to them and away from stocks. Take a deeper look at why yields matter.
Tariff: Increased duties that are levied by countries on goods they import to protect domestic industries. These levies make the imported goods less attractive to domestic consumers. But even as this is expected to be a shot in the arm for the domestic economy, it has other consequences like upsetting trade partners who may retaliate, setting off a trade war. When this occurs with a significant trading partner, the future of large corporations that conduct business in those countries come under question, putting pressure on the stock markets.
At Investopedia, we have over 30,000 financial terms in our Dictionary. Feel free to read them all, or just the ones that you're curious about. But seriously, knowing the language of financial markets can only make you smarter and a better investor. That's our mission and we are happy to serve. #StaySmart