Financial Terms Glossary

O

Oligopoly

An oligopoly is when a small number of businesses (usually less than 10) control the vast majority of the market with a large number of very small competitors operating on the fringe. The classic example of an oligopoly is the US telecoms industry where 4 firms have a market share of 89% (AT&T, Verizon, Sprint, T-Mobile).

Oligopolies typically compete on either price or product, rarely both. There are many allegations of price fixing and collaboration on higher prices within markets controlled by oligopolies.

Open

Open refers to the price at which a security began a period of trading, as well as the beginning of a period of trading for an overall market. Two examples of how the word open would be used are:

  • The Dow Jones opened 2% down
  • J.P.Morgan opened at $35
Option

An option is a financial derivative that gives the holder the right, but not the obligation to buy or sell a financial asset at a pre-determined price during a pre-determined period. The issuer of an option has to comply with the wishes of the option holder, regardless of whether it is a financially good deal.

There are two kinds of options:

  • Put - the option to sell
  • Call - the option to buy

Options are used as a means of hedging or of relatively leveraged speculation (this is not leverage in the usual form as there is no requirement to borrow money and the losses are limited, but the potential returns are higher than with other investments).

There are 3 key terms to know when considering options:

Strike Price - the value at which the shares can be sold (i.e. $200), regardless of the current market value

Exercise Date - the date by which the option has to be exercised or expires

Contract - the contract of an option provides the buyer with exposure to 100 shares. The price of an option is always per share amount so the cost of the contract will be multiplied by 100

An example of how options work is as follows:

  • Investor A sells Investor B a put option on Morgan Stanley for December 2012 at a strike price of $15 per share, for a cost of $0.05 per share ($5 total).
  • If in December 2012 the value of Morgan Stanley shares is $17.50, then the option is worthless. Investor A has made $5 and Investor B has lost the value of the options ($5).
  • If in December 2012 the value of Morgan Stanley shares is $12.50, then the option has value. Investor A has lost $245 (the difference between 100 shares at $15 and at $12.50, plus the $5 from Investor B).
  • In the second scenario, Investor B has made $245 (the difference between the market value of $12.50 and the option share value of $15, minus the $5 paid for the option.

The hard part about using options is that there is a time factor included. It is not enough to merely predict that the share price will rise or fall, you must also predict when it will do so.

Options are often preferred to buying shares outright in the market due to the fact that the maximum loss is less than on shares, and the return percentage is much higher. An example to illustrate this is shown below.

  • Investor A buys 100 shares of Apple at $375 for a total cost of $37,500
  • Investor B buys a call option for March 2012 on Apple with strike price $400 for a total cost of $500 ($5 x 100)
  • In March 2012 the price of Apple shares is $300
  • Investor A has lost $7500 ($75 x 100)
  • Investor B has only lost his maximum amount of $500
  • Now assume in March 2012 the price of Apple shares is $500
  • Investor A has made $12,500 profit ($125 x 100) that is a return of 33%
  • Investor B has made $9,500 profit ([$500 x 100] - [$400 x 100] - $500) which is a return of 900%

This shows how options provide improved returns and reduced maximum losses over buying shares; the risk is that options can easily expire worthless whereas shares usually still have value.

P

Penny Stock

A penny stock is one with an extremely low value, usually issued by a very small and risky company. Penny stocks are frequently bought for speculative purposes, and many fail. The reasoning behind purchasing them is that percentage gains are much easier to achieve than with larger companies. For example, it is more likely that a stock will go from $0.01 to $0.02 (a 100% return) than it is for a stock to go from $200 to $400.

Penny stocks often have large price spreads due to the lack of a liquid market for them and the difficulty in pricing them.

Despite the name, many penny stocks can be worth up to $5 or even $10, the term just refers to low value shares.

Pink Sheet

Pink sheets are a series of documents issued daily by the National Quotation Bureau which lists the bid / ask prices of OTC stocks. It also lists the traders who are the market-makers for these stocks. Companies listed on the pink sheets are not traded on a public stock exchange and are not subject to the same regulations as the publicly traded stocks.

Stock symbols traded via pink sheets end in .PK.

Ponzi Scheme

A Ponzi Scheme is a type of financial fraud pioneered by Charles Ponzi in 1919. The idea behind a Ponzi Scheme is that investors are offered high return and low risk and are therefore encouraged to invest. However, there is no actual investment going on with the funds, the return is simply provided by more investors joining the scheme. This can continue indefinitely and investors can receive their high returns, but as soon as the Ponzi scheme fails to attract enough new investors, the original investors will lose money.

For example, if a fund running a Ponzi Scheme offers investors a 10% return for an investment of $10,000 and there are 5 initial investors, the total invested is $50,000 and the fund needs to return $5,000 to those investors. In order to do this, the fund requires an additional investor and uses their money to pay off the original 5. However, it now needs to provide that 10% return to the newest investor and must therefore find another and this goes on and on until eventually no new investors can be found.

One of the most famous Ponzi Schemes was run by Bernard Madoff who defrauded investors out of over $50 billion during the early 2000s.

Position

Position is a term used in trading to refer to any current exposure a trader has. This means any trade they are currently in the process of doing. For example, if a trader wants to open a position in gold, they would attempt to gain exposure to the gold market through an ETF or any other method.

Premium

In a deal scenario, a premium is the difference between the amount paid and the value of the company. This premium usually illustrates the amount of goodwill in the target company and also how much the acquirer is committed to the deal and improving the future performance of the target firm.

Price To Earnings (P/E)

Price to Earnings (P/E) is a financial metric which shows the ratio of a firm's current share price to its earnings per share. This is an extremely common multiple used to evaluate whether a company is under or overpriced. Usually the higher the P/E ratio, the more overvalued the firm is.

The calculation of P/E is:

  • Market Value Per Share / Earnings Per Share

For example, if a share is currently trading at $50 and EPS are $2 per share, the P/E ratio is 25 ($50 / $2).

The P/E of different firms cannot really be compared unless they are in the same sector as the typically P/E values will vary between sectors. Technology firms for example usually have high P/E ratios.

Principal

Principal is a term used when talking about debt and loans. The principal is the initial amount of loan which has to be repaid, and this is separate from any interest payments. For example, the face value of a bond is the principal of that bond (separate from the coupon). Bond payments are interest-only until maturity as the issuer does not pay off any of the principal until maturity, but only pays the interest due.