Safe Trading Blog

Overview: Two major gold indices dominate the market–the Philadelphia Stock Exchange’s XAU and the AMEX’s Gold BUGS Index (HUI). The major difference between the two is that the BUGS index is made up exclusively of mining stocks that do not hedge their gold positions more than a year-and-a-half into the future. This makes the BUGS Index much more profitable than the XAU when gold prices are rising, but can also compound its losses when gold declines. BUGS is an acronym for Basket of Unhedged Gold Stocks. The index was introduced on March 15, 1996 with a starting value of 200.

Composition: The AMEX Gold BUGS Index is comprised of 15 of the nation’s largest “unhedged” gold mining stocks. It is a “modified equal-dollar weighted” index. As a result, most of the index’s component stocks are equally weighted, yet the largest stocks still carry a greater weight than the smallest.

Positives: When gold prices are on the rise, the Gold BUGS Index provides an excellent way for investors to capitalize on that increase. The index has a high correlation to the spot price (current price) of gold.

Drawbacks: When the price of gold declines, the Gold BUGS Index tends to fall much faster than its hedged cousin, the XAU. In addition, the firm’s unusual index weighting system can be difficult to understand.

Simple hedging HUI/GOLD:  The value of the HUI index is fundamentally based on the price of gold, everything else is just noise. One should be able to determine a theoretical “correct value” for the HUI index, depending solely on a ratio of the HUI to the price of gold. Any advance in the HUI index far above an idealized HUI/gold ratio should be sold. Any decline of the HUI index far below the HUI/gold ratio should be bought.

American Stock Exchange (AMEX) - Second largest stock exchange in the US.
AMEX Market Value Index - Measurement of all stocks on the American Stock Exchange.
Asking price - The price an investor pays to purchase stock.
At-the-money option - when the strike price of an option is the same as the current market price of the underlying commodity. For example, suppose the strike price on a June gold option is $305; and gold is now trading at $305. That option is at the money.
At the money - The condition that exists for an option when its underlying stock reaches the strike price before its expiration date.
Bear - a person or who thinks market prices are going to fall.
Bear market - when market prices are falling.
Bid - an offer to buy a specific commodity, at a specific price.
Bid price - Price the investor receives for sale of stock.
Blue-chip stock - Stock of a large, stable, well-established company.
Broker - A company or individual that facilitates a stock transaction but does not have ownership of the stock at the end of the sale.
Bull - a person who thinks market prices are going up.
Bull market - A prolonged period of rising stock prices.
Buy-and-hold - A strategy in which an investor purchases securities and holds on to them taking into consideration the long-term outlook of the underlying companies.
Call option - An option that give you the right to buy a specific commodity or financial instrument, at a set price, on or before a specific date. When you own an option, you do not have to buy the underlying commodity. The price you pay to buy the option itself is called the “premium”.
Canceling order - an order that cancels, or deletes, your previous order with your broker.
Capital gain - Money an investor earns by selling stock for a profit.
Capital loss - Money an investor loses by selling a stock for less than was paid for it.
Charting - using charts and graphs to analyze markets, so you can predict where market prices are going in the future. (Used in “Technical Analysis.”)
Close an option position - To buy and sell back an option to make a profit.
Closing price - The last price paid for a commodity or financial instrument on any trading day. This is the price the exchange clearinghouse uses, to determine each firm’s gains or losses for the day. Also called “settlement price.”
Commission - a fee brokers charge to execute your transactions. Also called a “brokerage fee.” Commissions vary between brokers. Discount brokers will usually execute your orders at much lower commissions.
Contract - an agreement to buy or sell a commodity, specifying the amount and quality of the product, and the date when the contract matures and can be delivered.
Covered option - An option that is written by an investor who owns shares of the underlying stock.
Crash - A large drop in the overall value of stock prices on a particular day or period of days.
Day Trader - An investor who buys and sells based on small short-term stock price fluctuations
Depreciation - Loss of value of an asset.
Derivative - A security whose value is based on another security such as Options and Futures.
Dip - Slight drop in securities prices after an upward move.
Discount Broker - A brokerage house that executes orders to buy and sell securities at sharply lower rates than a Full Service Broker. They usually offer almost no service or advice but trade for a reduced commission.)
Dividend - distribution of earnings to shareholders, prorated by class of security and paid in the form of money, stock or scrip.
Dividend yield - Annual percentage of return earned by an investor on a common or preferred stock.
Downside Risk - Estimate that a security will decline in value and the extent of the decline, taking into account the total range of factors affecting market price.
Downtick - Sale of a security at a price below that of the preceding sale.
Downturn - Shift of an economic or stock market cycle from rising to falling.
Dumping - Offering large amounts of stock with little or no concern for price or market effect.
Earnings per Share - EPS - Measure of a company’s profitability calculated by dividing net income by shares outstanding on the income statement.
Earnings-Price Ratio - Earnings yield - earnings per share to current stock price relationship.
Economic Growth Rate - Rate of change in the Gross National Product as expressed in an annual percentage.
Economic Indicators - Key statistics including unemployment rate, inflation rate, factory utilization rate and balance of trade which shows the direction of the economy.
Economic Risk - The danger to investors that the economy will decline.
Exercise - When a person who owns a call option buys the underlying security; or a person who owns a put option sells the underlying security.
Exercise An Option - To buy or sell the underlying stock of an option.
Federal Trade Commission - FTC - US government agency that regulates competitive markets with regard to encouraging free trade and discouraging monopolies.
Fill-or-kill - a price limit order that must be filled at once or get canceled.
Fundamental analysis - Analyzing markets by looking at their underlying economic, political, and supply-demand relationships.
Futures contract - A contract made on the floor of a futures exchange, to buy or sell a commodity or financial instrument at some date in the future. Futures contracts list the commodity; the date; the amount of the commodity; and the price.
Futures Option - Option on a futures contract.
Going short - Selling a stock or commodity that the seller does not have, usually betting that the price will go down.
Good-till-canceled order - An order you place with your broker, which stays valid until you cancel it. Also called an “open order.” (Restrictions vary depending on broker.)
Horizontal spread - Buying a put or a call, and at the same time selling the same option, with the same strike price, but with a different expiration month.
Index Fund - A mutual fund that invests in all the stocks of companies in a particular index.
Index Option - An option with a stock index as its underlying asset.
Insider Trading - Illegal manipulation of the stock market with profit as the intent by employees and officers of a corporation through the use of information not available to the public.
Interest - Payment for money that is borrowed.
In-the-money option - An option that has intrinsic value. For a call option, that means the strike price is less than the current price for the underlying commodity. That lets you buy at the lower strike price, and immediately sell at the current market price, for a profit.
Lapsed Option - Option that reached its expiration date and is now without value because it was not exercised, also called an expired option.
Last trading day - The final day when trading may take place in a given futures or options contract month. If you have any contracts outstanding at the end of the last trading day, you must settle them. You do this by delivering the underlying commodity, or by agreeing to a money settlement.
Leverage - The ability to control large dollar amounts of a commodity, with a small amount of capital. Options and Futures allow you to control large amounts of shares with minimum investment.
Limit order - An order for a commodity on the futures exchange, to buy or sell at a designated price. When you are buying, you place limit orders below the market. When you are selling, you place limit orders above the market. If the market never gets high (or low) enough, your limit order will not be triggered.
Long - A person who has bought stocks or commodities, hoping that price will go up.
Market order - An order to buy or sell a stock or commodity at the best possible price, and as soon as possible. Also known as placing an order “at the market”.
Mutual Fund - An investment company that pools the resources of individuals to enable them to diversify in a variety of investments.
NASDAQ Stock Market - National Association of Securities Dealers Automated Quotation System - electronic based equity market operated by NASD.
NASD - National Association of Securities Dealers - a self regulated organization of brokers and dealers responsible for the operation of the NASDAQ Stock Market.
NYSE - New York Stock Exchange - largest and most active stock market.
Option - a contract that gives you the right, but not the obligation, to buy or sell a particular item, at a set price, for a set time period.
Option premium - The price you pay to buy an option.
Option spread - Buying and at the same time selling one or more options contracts, futures, and/or cash positions.
OTC - Over the counter - securities trading via computer, telephone or direct negotiations.
Out Of The Money - When the underlying stocks of options are below the strike price for calls or above the strike price for puts.

Besides the primary financial assets discussed in previous posts (stocks, commodities, exchange rate), many other financial instruments, such as options and futures contracts, are traded on organized markets (exchanges). These securities are generically called derivatives, because they derive their value from the price of some primary underlying asset. The most basic derivatives are options. An option is a contract that gives its holder the right, but not the obligation, to buy or sell a certain asset for a specified price at some future time. The other part of the contract, the option underwriter, is obliged to sell or buy the asset at the specified price. The right to buy (sell) is called a call (put) option. If the option can only be exercised at the future date specified in the contract, then it is said to be a European option. American options, on the other hand, can be exercised at any time up to maturity. Thus, options are “contracts” that give you the right, or the “option” (but not the obligation) to buy or sell a stock or commodity, at a specific price, over a specific period of time. So, you’re not really buying the stock. You’re buying a ‘contract’ - you’re making an agreement that allows you to buy or sell the stock. Getting options is a lot like paying for insurance. For example, if you pay auto insurance for next month and nothing happens by the end of that month, the money you paid is gone. You don’t get it back. If something does happen by the end of next month, you will receive a payout, depending on how major the incident was. Options offer you leveraged profit potential…

Another way to speculate on the variations of the major indices (as Dow Jones, NASDAQ, S&P500) is by dealing with “Futures” contracts. They are standardized contracts, traded on a futures exchange, to buy or sell a certain underlying instrument at a certain date in the future, at a specified price. The future date is called the delivery date or final settlement date. The pre-set price is called the futures price. The price of the underlying asset on the delivery date is called the settlement price. A “futures” contract gives the holder the obligation to buy or sell, which differs from an options contract, which gives the holder the right, but not the obligation. In other words, the owner of an options contract may exercise the contract. Both parties of a “futures contract” must fulfill the contract on the settlement date. The seller delivers the commodity to the buyer, or, if it is a cash-settled future, then cash is transferred from the futures trader who sustained a loss to the one who made a profit. To exit the commitment prior to the settlement date, the holder of a futures position has to offset his position by either selling a long position or buying back a short position, effectively closing out the futures position and its contract obligations. Futures contracts, or simply futures, are exchange traded derivatives. The exchange’s clearinghouse acts as counterparty on all contracts, sets margin requirements.

A general introduction to main instruments available on financial markets is useful. The purpose in this post is to get a general knowledge to make the most profit of the next chapters of our report. There exist risk less and risky assets. A bank (saving) account is an example of a risk less financial asset, since you are guaranteed to receive a known (usually fixed) interest rate, regardless of the market situation. Roughly speaking, the way banks operate is that they borrow from people who have money to ‘spare’, but are not willing to take risks, and lend (at higher interest rates) to people who ‘need’ money, say, to invest in some risky enterprise. By diversifying their lending, banks can reduce their overall risk, so that even if some of these loans turn bad they can still meet their obligations to the investors from whom they borrowed.

Governments and private companies can also borrow money from investors by issuing bonds. Like a bank account, a bond pays a (fixed or floating) interest rate on a regular basis, the main difference being that the repayment of the loan occurs only at a specified time, called the bond maturity. Another difference is that bonds are not strictly risk free assets because there is always a chance that the bond issuer may default on interest payments or (worse) on the principal. However, since governments have a much lower risk to default than corporations, certain government bonds can be considered to be risk free.

A company can also raise capital by issuing stocks or shares. Basically, a stock represents the ownership of a small piece of the company. By selling many such ‘small pieces’, a company can raise capital at lower costs than if it were to borrow from a bank. As will be discussed shortly, stocks are by definition risky financial assets because their prices are subjected to “unpredictable” fluctuations. In fact, this is what makes stocks attractive to aggressive investors who seek to profit from the price fluctuations. When you buy or sell a stock on the open market, you should keep in mind that you are dealing with real objects, not pieces of paper; you are buying and selling real parts of a particular company, its product, or some other various commodity. Owning a “share” means that you have actually bought into the company or product involved and become a partial owner of that commodity. Of course, you could be one of millions of shareholders, as most companies and products are broken into minute pieces of the whole, but you are still considered an investor in that company or product until you sell your shares.

The buying and selling of stocks are usually done in organized exchanges, such as, the New York Stock Exchange (NYSE). Most stock exchanges have indices or benchmarks that represent some sort of average behaviour of the corresponding market. Each index has its own methodology. For example, the Dow Jones Industrial Average (or Dow Jones) of the NYSE, which is arguably the most famous stock index, corresponds to an average over 30 industrial companies. Others well known US stock indices are the Standard & Poor’s 500 (S&P500) index calculated on the basis of data about 500 companies listed on the NYSE and the NASDAQ index based on major technology companies.

Forex is the nickname for the Foreign Exchange Market. In the United States, there are several branches of the stock market, each with their own name. For instance, some stocks trade on the Dow Jones, others on NASDAQ. Of course, all stock market transactions in the United States take place on the New York Stock Exchange (NYSE). In other countries the same is true. There may be one or more distinct markets. However, international trade takes place on the market termed the Foreign Exchange Market, or Forex. Several countries across the world in almost every time zone participate in trade on Forex, with multiple currencies being utilized and stocks and commodities from all participating countries being offered for trade. Because there are so many nations and time zones involved, Forex does not function as a “business day” entity like most domestic stock markets. It remains open for trade 24 hours a day, 5 days a week. Of course, these additional hours increase the risk factor intensely for those of us who are human and obviously cannot monitor our investments 24 hours a day. This means that the value of your holdings could potentially plummet overnight, while you sleep, because other countries are still trading while you are in a dream world. Forex Functionality While the functionality of Forex is the same as a domestic stock exchange, the commodities and prices are more volatile, and there are additional factors to take into considerations besides the typical risks associated with a domestic market. You will have to contend with not only the value of your stocks and your currency, but also the foreign currencies involved in any trades or exchanges on Forex, as well as the inconsistencies of values of particular goods and services across international borders. The History of Forex When foreign trade began, it was not an international trade market. It was born out of the Bretton Woods agreement in 1944, which set forth that foreign currencies would be fixed against the dollar, which was valued at $35 per ounce of gold. This precedent was first put into practice in 1967, when a bank in Chicago refused to fund a loan to a professor in sterling pound. Of course, his intention was to sell the currency, which he felt was priced too high against the dollar, then buy it back later when the value had declined, turning a quick profit. After 1971, when the dollar was no longer convertible to gold and the domestic market was stronger, the Bretton Woods agreement was abandoned, and the currency conversion process became more variable. This allowed for a stronger backing in the foreign markets, and the United States and Europe began a strong trade relationship. In the 1980s, the market hours and usage was extended through the use of computers and technology to include the Asian time zones as well. At this time, foreign exchange equaled about $70 billion a day. Today, about twenty years later, the trade level has skyrocketed, with trade equaling close to $1.5 trillion daily. Originally, trading across international lines was more difficult, with several different currencies involved across Europe. Though the major players in the European market were deeply involved in and veterans of international trade by the time other markets joined in, there were more currencies to keep track of – the franc, the pound, the lira, and many more – than was reasonable. With the birth of the European Union in 1992, the wheels were set in motion to create a single currency that would be used across most of Europe, and the Euro was finally established and put into circulation in 1999. Forex Today While some countries have still not accepted the currency as their own (such as Britain, who still uses the sterling pound), the process of currency conversion has been simplified without the large number of various currencies that were previously dealt with. Instead of dozens of currencies, the main countries trade in five – U.S. dollars, Australian dollars, British pounds sterling, the Euro, and the Japanese Yen. Today, the Foreign Exchange Market is international and worldwide. The market is open 24 hours a day, 5 days a week, to accommodate all of the time zones for all of the major players. These now include most of Europe, the United States, and Asian markets, especially Japan. Even Australia has joined the international trading markets, and since such nations are halfway around the world from some of the other top players, time zones obviously must be taken into consideration. Another completely separate but perhaps more important concern with trading in Forex understands how trade works in multiple currencies. How can you compare the value of a stock across international lines if the values are expressed in two separate, non-equivalent currencies? And how do you measure gains and losses when conversion rate is constantly changing? Understanding Currency Conversion If you begin trading on Forex, you have to learn how to convert currencies and note the difference in values, as well as how currencies are exchanged between international lines. This means studying not only domestic market trends and currency values, but also those of foreign markets. Since Forex is the Foreign Exchange Market, you obviously cannot expect everyone within the market to trade in U.S. dollars (and why not, you might ask? – but remember that not everyone covets the U.S. dollar). With so many variables and volatile currencies being exchanged, how can you know a good buy or sell when you see one without complete awareness of the value of foreign currency? The first step is to find a source that will give you a basic idea of the current exchange rate between your domestic currency and the foreign currency in question. You should do this as a base listing for any currency that with which you might become involved. Of course, this will not be consistent down to the cent or fraction of a particular currency throughout an entire business day, but at least you will have your starting point from which to begin, almost like North on a compass. Such sources can be found all over the Internet, as well as through many brokers, both on line and in person. Currency Expression It is also good to understand the means by which the currency conversion is expressed. The comparison is usually made in a ratio known as the cross-rate. In this configuration, the two currencies are listed in an XXX/YYY ratio, with the XXX position referred to as the base currency. The base currency is usually expressed as a whole number, while the YYY position is expressed as the decimal that most closely matches the based currency rate. It is sort of like making reference to miles per gallon or rotations per minute on a car – a direct comparison of one to the other in the form of a ratio. The smallest fraction, or decimal, in which a currency can be traded, is called a pip and this is usually the degree to which a cross-rate is expressed. For example, if the British pound sterling can be traded in thousandths, the currency will be expressed to the third decimal place. The most common currencies found in Forex are the U.S. dollar, the British pound sterling, the Euro, the Japanese yen, and the Australian dollar. For illustration purposes, we display below the EUR/USD time evolution over the last two years.